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Four factors that will determine how high oil prices will go

Opec's agreement to cut production does not portend runaway oil prices

Published: Dec 1, 2016 06:45:43 AM IST
Updated: Dec 1, 2016 03:13:23 PM IST

Four factors that will determine how high oil prices will go
The OPEC logo is seen outside their headquarters in Vienna, Austria.
Image: Leonhard Foeger/Reuters

If there is one economy that has immensely benefited from low oil prices it is India. It has offered the Indian government a huge windfall, which has been partly used to increase public spending on infrastructure and the balance has gone to improve the budgetary deficit.

So The Organization of Petroleum Exporting Countries’ (Opec) recent decision, its first in eight years, to cut crude oil production by 1.2 million barrels per day (mbpd) should be worrying. Global oil prices moved above $50 a barrel after it became clear that an agreement has been struck among Opec members to cut the current production by 4.5 percent capping the overall output at 32 mbpd.

So, is the era of low oil prices over? Will high oil prices push up inflation and smother any hope of further interest rate reduction that is needed to speed up India’s economic growth?

Four factors will determine whether the oil prices will move northwards and if so, to what extent.
Compliance: Opec members are historically known to be notorious when it comes to cheating on their agreed quotas. They typically want the best of both the worlds —higher prices and higher output. In the past, such behaviour has neutralised the effects of such deals. The deal struck in Vienna on Wednesday has not been to the satisfaction of every member. Iran wanted to produce as much as 4 mbpd as it has just come out of sanctions that prevented it from selling oil globally. Its output has been capped at 3.8 mbpd. Iraq’s demand for allowing it to produce more on the ground that it needs money to fight ISIS has not been fully granted. Venezuela’s government and economy are in dire straits and higher oil prices is too tempting for it to not take advantage off to raise more revenue. Saudi Arabia, for its part, has agreed to cut as much as 0.5 mbpd to ensure the deal is concluded. The deal was clinched more on account of the fear that in the absence of an agreement, oil prices would crash to about $30 a barrel and not because all members were happy with the outcome of the negotiations.
Non-Opec output: Members of Opec produce just 30 percent of the global oil output. So their clout, in a way, is limited unless some of the non-Opec producers play ball with them. Russia has said that it will cut output but others such as Brazil, Canada and Kazakhstan are unlikely to do so. They may increase their production. Unless non-OPEC producers join in, the impact of this cut will be marginal.
Shale oil: Then there are the shale oil producers in the US. They were definitely hit by low oil prices but they were not finished as Saudi Arabia had hoped. They will increase output as oil prices increase and this will partially offset any effects of Opec’s cut. Also Donald Trump, the US president-elect has vowed to remove all the regulatory bottlenecks that come in the way of shale oil and conventional oil production in the US. So expect US to import less oil in the future.
Global growth: Global economy continues to stutter. Two of the world’s fast growing economies are facing head winds. China is not seeing any recovery and effect of demonetisation on the Indian economy is likely to be negative, at least in the short run. Many other large economies are battling recession. So a sharp increase in oil demand is unlikely in the near future.
Considering the above factors experts agree that the production cut deal by Opec has for sure set the floor price of oil at around $48-50 levels. It is unlikely that the prices will move up too sharply. They opine that it may move between $50-60 depending how well Opec members behave (in not cheating) and how successful they are in co-opting non-Opec players to cut output. The $50-60 price band of crude oil is something that India can live with comfortably. Anything more, and it would start to worry policy makers.

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