OPEC+’s Slashed Supply Of Oil: Here’s How To Navigate Markets’ Ripple Effects

OPEC+’s Slashed Supply Of Oil: Here’s How To Navigate Markets’ Ripple Effects
Stéphane Renevier, CFA

11 months ago5 mins

  • OPEC+’s cuts are likely to support prices in the near term, but probably won’t shoot the lights out – unless the global economy gets a lot stronger.

  • But the biggest risks are to the upside, which means there could be important knock-on effects for growth and inflation, in turn complicating an already delicate balancing act for central banks.

  • In this uncertain macroeconomic climate, you could do well by diversifying assets to withstand multiple scenarios, including holding treasury bonds, gold, commodities, and a small amount of bitcoin alongside your stocks.

OPEC+’s cuts are likely to support prices in the near term, but probably won’t shoot the lights out – unless the global economy gets a lot stronger.

But the biggest risks are to the upside, which means there could be important knock-on effects for growth and inflation, in turn complicating an already delicate balancing act for central banks.

In this uncertain macroeconomic climate, you could do well by diversifying assets to withstand multiple scenarios, including holding treasury bonds, gold, commodities, and a small amount of bitcoin alongside your stocks.

OPEC+, the group of oil-producing nations, announced it would voluntarily cut a collective 1.66 million barrels of output per day from May until the year’s end. And while the group cited its need to "support the stability of the oil market" as motivation, the move came without warning – and during a period of decent market fundamentals and relatively high oil prices.

The decision caught the world off guard, sending shockwaves through global oil markets. Oil prices boasted their biggest daily gain in over a year, while the price of shorter-term contracts rose above that of longer-term ones (a phenomenon known as “backwardation”) for the first time since December, indicating that traders are worried about the risk of supply falling below demand.

What does the supply cut mean?

Several factors could be driving the cartel's decision. It might want to show the US that the world doesn’t revolve around the land of Red, White, and Blue anymore, a possible sign of retaliation after US officials recently ruled out fresh crude oil purchases to replenish the country’s Strategic Petroleum Reserve. The cut could also be a reminder to short-sellers about the risks of betting against falling prices, or a simple attempt to fatten up its revenue so the group’s members can splash out on other projects. (After all, the group’s in a more dominant position than ever before, meaning higher prices will likely more than offset lower volume). Or maybe it’s anticipating such a drop in demand that it wants to pre-emptively limit the downside in prices.

The reality’s probably a mix of all those explanations, but in any case, the end result is the same. Oil prices are likely to stay propped up in the near term, but probably won’t shoot the lights out – unless the global economy gets a lot stronger. See, the cut should suck the surplus supply out of the market, in turn pushing world oil markets into a deeper deficit later this year. And don’t expect shale producers to come to the rescue: they’ve become increasingly price inelastic, meaning their output plans are hardly affected by price changes at all. And despite being flushed with cash, they prefer to distribute their profit to shareholders instead of reinvesting it in production. So as you can see in the chart below, demand will probably tower over supply from as early as June. The gap’s likely to widen over the rest of the year, fueling prices as a result.

Demand will probably tower over supply from as early as June. Source: Goldman Sachs
Demand will probably tower over supply from as early as June. Source: Goldman Sachs

Still, OPEC+’s output slash is probably a harbinger of weaker demand. And historically, supply-driven deficits haven’t lit a fire under oil prices in the same way as demand-driven ones. That’s why the base case scenario here looks more like slightly higher prices, rather than crazily higher ones. Even Goldman Sachs – one of the most bullish banks when it comes to oil – has only upped its price target for the end of this year by $5, from $90 to $95, and to $100 for next year. (Of course, prices are likely to miss the mark if the economy falls into a more serious recession.)

On the whole, though, the upside risks arguably trump the downside ones. OPEC+’s greater-than-ever pricing power may allow it to intervene in markets to prevent further price falls (i.e. creating an “OPEC put”). Meanwhile, a stronger global economy – including freshly invigorated China – would bring about an extra appetite for fuel, exacerbating the deficit and sending prices much higher. Let’s take a look at the historical distribution of inflation-adjusted oil prices (to make them more comparable over time), and you’ll see that you can’t underestimate the risk of oil prices moving much higher in a robust economy. As you can see in the chart, oil prices (expressed in 2023 dollars) have hit the $130 to $140 range almost three times as frequently as they’ve landed in the $100 to $110 one. There’s no guarantee that’ll happen here, sure, but it’s a clear lesson that prices can fly higher than investors expect when they have momentum on their side.

Historical distribution of inflation-adjusted oil prices. Source: Morgan Stanley
Historical distribution of inflation-adjusted oil prices. Source: Morgan Stanley

Why should you care?

Higher oil prices can have major knock-on effects. They not only pump up headline inflation, but also tend to influence investors’ expectations of future inflation. And sure, as long as the price gains stay limited, they might not actually impact the Federal Reserve’s inflation-fighting decisions. But the threat of mounting oil prices may force the Federal Reserve and European Central Bank to consider more hikes, even if they are concerned about stress in the banking system or a looming recession. In short, rising oil prices complicate an already delicate balancing act for central banks, and heighten the risks of something going wrong.

A higher oil price isn’t what the economy needs, either. That’s because rising oil prices don’t just squeeze consumers (if you spend more on petrol, you spend less on other things), but also companies (oil is an important cost of production, after all). In essence, the higher the oil prices, the bigger the potential hit to consumer spending and companies’ profit. And in turn, that pulls up the risk of a simultaneous negative shock to growth and stubbornly high inflation, leading to the dreaded “stagflationary environment” which has historically been bad for stocks.

OPEC+’s supply cut – and the resulting oil price spike – was completely unexpected, and served as a clear reminder of how uncertain the current macroeconomic environment is. With so many potential paths for the economy, the best thing you can do is diversify your assets to give yourself a better chance at surviving multiple scenarios. So make sure you aren’t just holding stocks, and consider treasury bonds (to protect against a hard landing), gold (to protect against a stagflationary scenario), commodities (to benefit from reflation), and a small amount of bitcoin (to protect against the unintended consequences of monetary and fiscal stimulus).

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