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OPEC’s strategy behind oil production cuts is not what you think

A flag with the Organization of the Petroleum Exporting Countries (OPEC) logo is seen before a news conference at OPEC's headquarters in Vienna, Austria, December 10, 2016.

Heinz-Peter Bader/REUTERS

On May 18, Merrill Lynch commodity strategist Francisco Blanch reiterated his theory that OPEC's production cuts were not, as popularly believed, designed to raise the price of oil. Mr. Blanch argues that the Organization of Petroleum Exporting Countries is instead trying to reshape the oil futures curve, which is a far more complicated and interesting thing.

Mr. Blanch detailed his thinking in a research report last October titled OPEC wants a triple-double. Central to this theory is that higher oil prices don't help OPEC member oil producers much. Mr. Blanch sees global oil demand as largely price-insensitive, meaning demand would not rise or fall significantly with changes in the crude. At the same time, U.S. oil production is very price sensitive – shale production can increase quickly if oil prices rise.

For Mr. Blanch, these patterns suggest that higher oil prices would mainly serve to increase global market share for U.S. shale producers at OPEC's expense, and it doesn't make sense as the primary goal for OPEC policy.

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In recent years the oil futures curve has been upward sloping – traders call this curve shape "contango" – which means that the commodity prices at which future commitments to buy and sell crude are contracted is higher than the spot price.

Currently, for instance, a U.S. shale producer looking to lock in a price to sell oil for delivery in May, 2022, could contract to sell at $51.21 (U.S.) a barrel in the futures market, about $2.75 a barrel higher than today. A futures curve in contango increases profits for forward-selling oil producers. In the past two years, Mr. Blanch estimates that the difference between spot and forward prices has allowed oil companies to increase revenues by between $6 and $9 a barrel sold (first chart below).

Forward selling is common among shale producers (and also Canadian oil sands companies, although their production is less sensitive to price). OPEC countries, which use forward selling far less often, have been at a profit disadvantage.

Mr. Blanch believes that OPEC's production cuts are designed to invert the futures curve from its current upward sloping contango (lower chart) into what's called backwardation – a downward sloping curve where futures prices are lower than the spot price. This would remove the profit boost from forward selling and increase OPEC countries' competitiveness and share of total oil earnings relative to shale producers.

So far, the cartel's efforts to reshape the futures curve have been thwarted by warm winter weather in major consuming regions, which caused a larger than expected build in inventory levels and pressured spot prices. Lower than expected crude demand from Mexico and India have exacerbated the problem.

The Merrill Lynch strategist, however, believes that backwardation is coming. He notes there is normally a nine-to-15-month lag between production cuts and futures curve changes and the global demand issues have merely delayed the process.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More

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