• The UAE’s decision to leave OPEC marks a major shift in the oil market, weakening the cartel’s ability to control supply and prices.
• In the short term, supply constraints owing to the Iran-US conflict limit the impact, but over time increased UAE production could push prices lower and make markets more volatile.
• Funds with exposure to energy companies, particularly UK-listed majors, stand to benefit from higher prices now and rising production later, although inflation remains a key risk.

This week, the United Arab Emirates (UAE) announced it would leave the Organisation of Petroleum Exporting Countries (OPEC), an international cartel of eleven member countries including Saudi Arabia, Iran, Iraq, Nigeria, Venezuela and Kuwait – accounting for 79.5% of the world’s proven oil reserves¹. The organisation’s members focus on cooperating on the supply of oil to fix prices and thereby maximise profits. The UAE has been a member since 1967, all but seven years of the organisation’s total existence², and its departure, effective as of the 1st of May, has the potential to cause major change for the oil market.

Geopolitics, quotas, and the limits of cooperation

We have written extensively recently about the effects of the Iran-US conflict on the global economy, and of course, this plays a major role in developments in the oil market too. With the price of crude surging back over US$100 per barrel again³, industry commentators are warning about permanent demand destruction, particularly in Asia⁴, which will cause severe and lasting economic disruption for the Gulf States.

Crude oil price, 1 year. Source: Trading Economics

Under current OPEC quotas, the UAE has been limited to a maximum production ceiling of 3 million barrels per day, constraining supply and leading to higher prices⁵. The country has been pushing for an increase to the quota of 5 million barrels⁵, which it is unable to achieve, requiring consensus from partners whose interests are not always aligned.

More to the point, OPEC is a volatile and fractious grouping of nations. The UAE has been fighting a proxy war with Saudi Arabia in Yemen and Sudan for years⁶, and has been subject to unprovoked attack by Iran on its oil infrastructure⁷. This most recent development has naturally focused minds on change.

From shipping limits to global oversupply

In the short term, the impact is likely to be negligible. Whilst the UAE might want to increase production and drive down oil prices, it is held up by the continued bottleneck in the Strait of Hormuz – no oil is leaving and capacity for storage is running out, meaning that oil production shutdowns are looming.⁸

The longer-term effects are more interesting. Assuming the Iran conflict is resolved in the coming weeks and months, investors expect to see the price of oil drop precipitously. On the initial announcement of a cease fire between Iran and US a few weeks back, the price of a barrel of crude fell from $115 to $82 in just a matter of days⁹, before quickly reversing. With the UAE looking to expand production, this would see the world oil supply increase, likely having an even more substantial impact on prices. Upon leaving OPEC, the UAE has the production capacity to pump over one million extra barrels of oil per day, roughly 1% of global supply¹⁰.

The ability to pump more oil and have greater control over the associated revenues may prove enticing to other OPEC members, prompting them to follow the UAE’s lead. Were this to happen, Capital Economics forecasts structurally lower oil prices in future, yet with much greater volatility due to there being less predictable supply. Indeed, even were it to just be the UAE leaving, OPEC’s price setting ability will be permanently weaker, given the UAE is second only to Saudi Arabia in spare production capacity¹¹.

OPEC price setting over time. Source: EIA / BP Statistical Review of World Energy. Annotations by Bowmore.

Bowmore portfolios

Oil majors with established production capacity in the UAE stand to benefit meaningfully. Both US firms such as ExxonMobil and UK-listed companies including Shell and BP are deeply embedded across the country’s exploration, production and trading value chain. Greater freedom to increase output should, in turn, support earnings growth. Given our sizeable allocation to UK equities, an area with significant energy exposure, our portfolios are well positioned to benefit in the near term from elevated oil prices amid the Iran conflict, and over the longer term from higher production volumes. Notably, Shell plc represents our third-largest underlying holding within Core portfolios.

Higher oil prices can be helpful for returns if interest rates remain stable, but if they begin to push up inflation, that could weigh on performance, which we have started to see as oil prices have risen.

Sources:

1. OPEC
2. OPEC
3. Trading Economics
4. OilPrice
5.  OilPrice
6. European Council on Foreign Relations
7. Long War Journal
8. Dow Jones
9. Trading Economics
10. Capital Economics
11. CNBC