OPEC's Dilemma: Demand Destruction Or Production Boost

Authored by Nick Cunningham via OilPrice.com,

The early signs of discontent and demand destruction could be forcing OPEC’s hand, but increasing production carries its own risks.

OPEC and Russia are considering raising oil production in a few weeks’ time, and while much of the focus has (rightly) been on the supply outages in Venezuela and the potential for disruptions in Iran, the prospect of demand destruction also looms large for the cartel and its partners.

Oil forecasters had been predicting a blistering oil demand growth for 2018. But lately, those bullish forecasts are not looking quite as good, precisely because oil prices had climbed to their highest level in more than three years. For instance, in May the International Energy Agency revised down its forecast for demand growth for 2018 from 1.5 million barrels per day (mb/d) to 1.4 mb/d.

But a growing list of other signs should cause OPEC some concern, and might ultimately push the disparate members of the group into agreeing on higher output.

A nationwide truckers’ strike in Brazil paralyzed the country. Truckers were outraged by the soaring cost of fuel. The expense is made worse by the fact that Brazil’s currency, the real, has declined significantly this year, doubling the pain for motorists in the country. The strike led to enormous damage to the agricultural sector, and led to shortages of a wide array of basic goods. The country’s GDP is expected to take a significant hit.

That strike was followed up by an oil workers’ strike, which forced the temporary shutdown of a series of refineries. The workers, as well as the truckers and a wide swathe of the country, are outraged about the cost of fuel, and they demanded an end to the more market-based pricing for gasoline and diesel that was introduced several years ago. The return to a more government-controlled pricing mechanism, while better for consumers, is costly for the government and for state-owned Petrobras. The oil company has been digging out of a mountain of debt, and if it has to take on the cost of regulated fuel prices, it might have to pile on more obligations.

Brazil is emblematic of the pain that consumers face when oil prices rise by so much in such a short period of time. There are similar signs of disgruntlement around the world. Bloomberg notes that there are plans or calls for changes to fuel prices in India, Thailand, Vietnam and Indonesia. The reactions vary in degree and approach, but across the world there is unrest at the rising cost of energy.

These developments will not be lost on OPEC and its non-OPEC partners as they gather in Vienna on June 22. Keeping the production cuts in place for the rest of 2018, which has long been the plan, could risk overtightening the oil market, potentially sending prices up towards $100 per barrel. That would lead to much wider economic pain and conflict. Ultimately, high prices would destroy oil demand, a development that would likely backfire on OPEC.

However, the flip side of this is that OPEC also faces risks if it decides to increase oil production.

While the specific fuel-related concerns are becoming increasingly visible on the ground, the macroeconomic environment is showing some signs of trouble. The most recent datafrom the global manufacturing PMI by IHS Markit puts global manufacturing growth at a nine-month low, “largely reflecting a waning of global trade flows to the weakest for over one-and-a-half years.”

At the same time, the Wall Street Journal notes that investor confidence in the Eurozone is at a multi-year low, a reflection of the trade war that has erupted between the U.S. and the EU, as well as the political turmoil in Italy, which has put the common currency back in the spotlight.

In short, the global growth story is starting to look a little shaky.

All of this puts OPEC in a tricky position. If it keeps the production cuts in place, oil prices could go too high. Historically, high oil prices help contribute to economic slowdowns, so OPEC runs the risk of sowing the seeds of an economic downturn, which would inevitably drag oil prices back down.

But, OPEC also faces risks by increasing output as well. The danger is that the global economy softens anyway, and OPEC ramps up production at the same time when the economic cycle moves into a slow phase. While higher oil supplies would lower prices and thus blunt the negative fallout of a cyclical downturn, OPEC would also be pumping oil just as the market needs less of it. The result could be a decline in prices far beyond what the cartel wants.

As a result, there are no clear or easy answers for OPEC and Russia when they meet in two weeks.