Market Extra: What the OPEC standoff means for oil prices and financial markets

United States

A standoff between Saudi Arabia and the United Arab Emirates has investors once again questioning the future of the Organization of the Petroleum Exporting Countries, or OPEC, while weighing implications for crude oil and financial markets.

Oil prices whipsawed Tuesday, hitting six-year highs before pulling back sharply, as traders weighed whether the stalemate over a call to further relax output curbs would keep crude off the market or spark a production free-for-all.

OPEC’s obituary has been written before, so talk of the cartel’s demise should be taken with a grain of salt. But there’s no doubt the organization faces a significant challenge as one of its key members, the U.A.E., attempts to assert its own influence.

Here’s what investors need to know about the conflict and what it means:

What happened?

The Organization of the Petroleum Exporting Countries and its allies, including Russia, in April 2020 approved a plan that cut oil production by 10 million barrels a day. They’ve slowly restored a chunk of that output as demand has picked up, leaving curbs of around 5.8 million barrels a day in place.

The group appeared on track last week to approve a proposal that would further ease existing crude oil output curbs by an additional 400,000 barrels a day each month from August through December — adding another 2 million barrels a day of production by the end of the year. The proposal also called for delaying the expiration of the underlying agreement on supply cuts from April 2022 until December 2022.

The U.A.E. objected. According to news reports and analysts, the country was fine with a further relaxation of output curbs, but argued it should be able to pump more. It called for lifting the baseline used to determine its output level and also objected to extending the expiration of the deal beyond April of next year.

Talks aimed at resolving the differences failed. An OPEC+ meeting on Friday ended with no agreement and a meeting planned for Monday was canceled after no progress was made toward resolving the dispute.

What did oil prices do?

Oil prices initially surged after the talks collapsed late Monday. After all, no agreement means that output won’t rise even as demand is expected to continue to grow over the second half of 2021 as the global economy recovers from the COVID-19 pandemic.

That was enough to send West Texas Intermediate crude CL00, +1.80% CLQ21, +1.80%, the U.S. benchmark, to its highest level since 2014. Global benchmark Brent crude BRN00, +1.60% BRNU21, +1.60% traded at a level last seen in October 2018.

But crude subsequently pulled back from those highs, with Brent ending the day down 3.4% and WTI settling with a loss of 2.4%. Traders said the selloff underscores uneasiness about the ability to hold the existing pact on output curbs together if the conflict can’t be resolved.

Analysts said the selloff unnerved equity investors and saw energy shares lose ground. The Energy Select Sector SPDR ETF XLE, -3.25% fell 3.2%, while the SPDR S&P Oil & Gas Exploration and Production ETF XOP, -4.07% dropped 4%. The Dow Jones Industrial Average DJIA, -0.60% ended the day down around 209 points, or 0.6%, while the S&P 500 SPX, -0.20% edged down 0.2%.

As of Tuesday, Americans were paying $ 3.13 for a gallon of gasoline, a seven-year high, according to the national average from AAA. A year ago, it was $ 2.18. A month ago, it was $ 3.05, according to AAA data.

Read: No OPEC+ deal on crude oil production — why that’s bad news for U.S. drivers

What’s the bullish case for oil prices?

Given that a number of high-profile players had been making the case for $ 80-a-barrel, or even $ 100-a-barrel, Brent before the breakdown in talks, the ability of OPEC and its partners to keep its output curbs in place is seen adding upside momentum to crude prices in the near term.

“Assuming that global oil demand revives later this year as travel restrictions (both domestic and international) are progressively lifted, we estimate that the rollover of the July quotas would deepen the global market deficit to around 2.5 million barrels per day in Q3 and Q4 2021,” said Samuel Burman, assistant commodities economist at Capital Economics, in a note.

“In this scenario, the spot price could soar, perhaps even to over $ 100 per barrel, in the coming weeks,” he wrote. “However, we anticipate that prices at these levels would be short-lived as some member states would probably seek to capitalize on higher prices and raise output.”

What’s the bearish case for oil prices?

Simply put, the worry hanging over the market is a production free-for all.

“The grave concern for crude bulls naturally comes in the unlikely event of a genuine feeling that this disagreement leads to something more pronounced, and the cartel move to a truly fractured situation — where market share and an output grab becomes a dominant theme,” said Chris Weston, head of research at Pepperstone, in a note.

Such breakdowns have happened in the past.

“The thing about cartels is that every member has an incentive to break cartel discipline and maximize revenues on its own,” said Carl Weinberg, chief economist at High Frequency Economics, in a note.

“In this case, undisciplined OPEC+ members may abandon the production restraint accord and raise output for individual gain, ultimately driving prices sharply lower,” he said.

And, Weston warned, if that were to happen, it would likely send ripples across financial markets.

“This dynamic would not be a one-day affair and a lack of cohesive action when spare capacity in the physical market is still elevated, would be a red rag to the shorts, and it would spill over into higher volatility in other asset classes too,” he said.

Is there any hope for a deal?

Don’t count out prospects for a compromise. In fact, it probably remains the most likely outcome, Burman said, noting that OPEC has previously demonstrated an ability to achieve “creative compromises.” And besides, the U.S. is also bringing diplomatic weight to bear in the search for a deal.

Any such compromise is likely to be modeled on the plan backed by Russia and Saudi Arabia to gradually lift output through the remainder of the year, perhaps with U.A.E. getting a new baseline or higher quota, Burman said. Ultimately, that may require delaying the discussion around the end of the existing output agreement until next year, he said.

In that scenario, Capital Economics sees oil peaking around $ 80 a barrel in coming weeks before falling as the gradual rise in OPEC+ supply takes hold.