London - Senior officials from the Organization of the Petroleum Exporting Countries and their allies (OPEC+) have offered a variety of explanations for last week's decision to reduce their collective production target.

The most common is that the organisation is being “proactive and pre-emptive” ahead of a possible downturn in the global business cycle and petroleum consumption.

Uncertainty surrounding the economy and oil market was cited in the group’s Oct. 5 press release announcing production targets would be cut by 2 million barrels per day with effect from November.

Other comments from ministers and officials in recent weeks have focused on the need to balance production and consumption, avoid an unplanned increase in inventories, boost investment or preserve spare capacity.

Some of these arguments are stronger than others. But the idea of holding some capacity in reserve so output can be increased during some future emergency is based on faulty logic, especially when inventories are already low.

In trying to keep inventories low through the cycle, OPEC+ risks worsening any global recession, and overtightening the market during the next upturn.

INVENTORIES AND SPARE CAPACITY

Inventories and spare capacity are alternative shock absorbers dampening short-term price swings caused by unanticipated changes in production or consumption.

If consumption is unexpectedly strong, or there is a sudden loss of output caused by sanctions, sabotage or accident, the first impact is a depletion of inventories or call on unused capacity.

Conversely, if demand disappoints, or supply grows faster than forecast, the first impact is inventory accumulation or idling of additional capacity.

Inventories and spare capacity are in some sense substitutes for each other.

The problem is that petroleum inventories around the world have already depleted to the lowest levels for more than a decade:

* U.S. petroleum inventories including the strategic reserve have depleted in 86 of the last 118 weeks by a total of 480 million barrels and are at the lowest seasonal level since 2004.

* U.S. distillate stocks have depleted in 69 of the last 118 weeks by a total of 66 million barrels and are at the lowest seasonal level since weekly records began in 1982. On a monthly basis, stocks fell to the lowest seasonal level since 1996, and before that 1954, in July, the most recent month for which data is available.

* European distillate inventories have fallen by 122 million barrels over the last two years and are at the lowest seasonal level since 2002.

* Singapore distillate stocks have fallen by 9 million barrels since late 2020 and are at the lowest seasonal level since 2006.

Inventories have fallen so low they can no longer play much of a role as shock absorbers in the event of stronger than expected consumption or a sudden loss in production.

Chartbook: Global petroleum inventories

SEVERELY DEPLETED INVENTORIES

The extreme backwardation in Brent futures prices is a symptom global petroleum inventories have become uncomfortably low.

Brent’s six-month calendar spread has softened into a backwardation of less than $9 per barrel from almost $22 in the aftermath of Russia’s invasion of Ukraine.

But the spread is still in the 98th percentile for all trading days since 1990, a signal the production-consumption-inventory balance is expected to remain tight.

Extreme backwardation implies the need to stem the two-year depletion of inventories and rebuild them to more comfortable levels by accelerating production and/or restraining consumption.

BALANCING RISKS AMID UNCERTAINTY

When spare capacity and inventories are both low, the volatility-reducing course is to put whatever spare capacity there is into production immediately to accumulate inventories pre-emptively.

Spare capacity can play a more useful role accumulating inventories before a positive consumption shock or a negative production shock than immediately afterwards.

If put into production, extra capacity can accumulate a stock of extra petroleum inventories over multiple months, whereas in the aftermath of a shock it can only supply a much smaller increase in daily flows.

The more volatility-reducing policy for OPEC+ last week would have been to leave production unchanged and allow inventories to rise modestly to more normal levels.

If over-production persisted for more than a few months and inventories ended up on course to rise above-normal there would be plenty of time for the group to reduce output.

By cutting production pre-emptively, OPEC+ is preventing inventories normalising, leaving them too low to avoid future shocks from higher consumption or lost output.

In the event that the global economy avoids a recession, China’s growth accelerates, or there is a major interruption to Russian oil supplies, inventories will be too low to respond and it will be too late to rebuild them.

PROACTIVE OR REACTIVE POLICY?

The proactive production cuts announced last week stand in contrast to the second quarter of this year when inventories were falling and prices rising rapidly.

In that instance, OPEC+ resisted calls from the U.S. government and other policymakers to boost output faster, preferring to wait and react to any future supply disruption rather than use reserve capacity to build inventories.

OPEC+ decision-making has been proactive in responding to rising inventories and falling prices, but reactive or passive in response to rising prices and falling stocks.

Even if the group presents its decisions in terms of balancing production and consumption, its actions reveal a preference for lower inventories and higher prices.

POLITICAL AND ECONOMIC FALLOUT

The OPEC+ decision has thrust the group into the heart of the diplomatic and economic maelstrom, whether that was its intention or not.

Saudi diplomats and surrogates insist the kingdom was acting only in its own interest to protect prices and maximise revenues in the context of a deteriorating global economy.

Most economic forecasters anticipate global growth will slow sharply in the remainder of 2022 and into 2023, which will induce a slowdown in oil consumption growth.

But the timing, duration and depth of the next downturn remains uncertain as does any reduction in oil consumption, either in absolute terms or relative to trend.

U.S. Treasury Secretary Janet Yellen has described the OPEC+ decision as “unhelpful and unwise” because it risks keeping prices for consumers high even as the economy weakens, worsening recessionary pressures.

The planned cut has also been denounced by policymakers in the United States as a diplomatic snub after President Joe Biden met with Saudi Arabia’s Crown Prince Mohammed bin Salman in July.

As a result, Biden is re-evaluating U.S. relations with Saudi Arabia, the White House spokesman told reporters on Oct 11.