Two months after setting the ball rolling in Algiers and eight years after it last cut output, OPEC agreed this time in Vienna to resume its efforts to prop up oil prices. The group announced cuts of 1.166m barrels a day, effective from the beginning of January, for six months. The deal may be renewed at the end of May.
The vast majority of market participants doubted the ability of the international oil cartel to agree on anything, much less and agreement to cut production. In the days leading up to the November 30 biannual meeting, it began to appear that the framework for a deal discussed in Algeria back in September was falling apart. The Saudis stated that they would not agree to any deal where all members of OPEC did not participate. In the background, the Russians worked to soothe egos and smooth over disputes.
Meanwhile, as the OPEC meeting approached, the biggest sign of the dubious nature of market participants for the prospects of any deal in the crude oil futures market. As this metric that measures the total number of open long and short positions increased above 2 million contracts, it appeared that speculators were placing bets on a continuation of the same from the cartel, rhetoric but no concrete deal.
At each of the biannual meetings since 2014, the market has held its breath for some supportive action from the cartel. However, OPEC kept on disappointing the oil market. This time, cartel’s members are feels cornered. There are three reasons why inaction by the cartel could mean oil will break below the $40 level.
The first reason that OPEC finds its back against the wall is history, which tends to repeat itself. After many of the past meetings that resulted in no action to fulfill the cartel’s mission to stabilize the oil price, the membership knows that the market reaction will be to sell causing the price to fall. It was the unsuccessful gathering of the cartel one year ago that led oil to trade to the lowest price since 2003.
Another reason for concern amongst the membership is the rise of the dollar. The dollar is the reserve currency of the world and the benchmark pricing mechanism for most commodities, including oil.
The dollar broke out to the upside and is currently trading at the highest level since 2003. A higher dollar tends to be bearish for commodity prices given the historical inverse price relationship between the U.S. currency and raw material prices. Actually historically, there has been a very tight inverse correlation between oil prices and the U.S. Dollar. During the last month or so I have watched the correlation between the strong dollar and the price of WTI lessen somewhat.
The dollar has spiked by more than 3% since the beginning of November and more than 6% over the just the past three months. That type of U.S. dollar surge should have been coincident with a meaningful ($10 plus) decline in oil prices. That did not occur as oil prices remained stable.
I am not sure exactly how to interpret this disconnect, perhaps it reveals more demand than analysts believe. Maybe the oil gurus sniffed out the OPEC production cuts.
The third one is that the U.S. Presidential election is not only a sign but a virtual guarantee that American oil production will increase in the months and years ahead. President-elect Trump ran on a platform of strategic energy independence and fewer regulations on the oil patch. Less regulation will mean that production cost in the U.S. will decline and output will increase in the years ahead. The U.S. is the third largest producer of crude oil in the world.
Politics and economics have put OPEC’s back against a wall. The involvement of the Russian President who has personally expressed his support of a deal that will stabilize oil and stated that Russia would do its part to make an agreement happen is another pressure on the oil ministers at this time.
Deal or no deal?
As I mentioned above, on November 30 OPEC did something it had not been able to accomplish for years, the cartel announced a 1.166 million barrel per day production cut that will take effect in January 2017. Saudi Arabia shouldered the majority of the cut, agreeing to lower daily output by 486,000 barrels. After the announcement, that sent oil futures higher, the Russians committed to a 300,000 barrel per day decrease in production but OPEC said in their statement that they intend to persuade the Russians to double their commitment to 600,000.
The engineering of the deal is likely the result of Russian influence and horse trading. Saudi Arabia had said that they would only agree to an accord if all other members of the cartel contributed. Iran, a stumbling block for the Saudis, agreed to freeze output at its current level which is a major coup for the theocracy which is a close ally of the Putin government.
It appears that some aggressive arm twisting by the Russians resulted in the deal. However, as with any deal the market will have to wait and see if the cartel will stick to its words in the statement.
The devil is in the details
OPEC has not yet released the exact production quotas for members and there is always a potential for cheating by the members. OPEC is likely to depend on an honor system which could produce dubious results. However, the deal is a first for the cartel who have now thrown in the towel officially on a strategy of flooding the market with oil to chase away North American shale output and build market share. We must remember that after the OPEC cut, the cartel is still producing two and one-half million barrels more each day than it was two years ago. The flood has lessened which is not a result that the market expected. Many market participants went into the OPEC meeting short as most speculators bet that the cartel would not come to any agreement.
Crude oil reacts
Crude oil futures reacted to the news from OPEC as shorts scrambled for an exit from their positions.
Active month January NYMEX crude oil futures settled at $49.44 per barrel on November 30 in the wake of the OPEC meeting, a gain of $4.21 per barrel on the session. On December 1, it was trading at the $51 per barrel level. The technical test for crude oil is now at the October 10 highs of $52.74. Brent crude oil, the benchmark crude for Middle Eastern production rose to highs of $52.36 on the February contract. On December 1 Brent was above $53.50 per barrel. The Brent premium over WTI is now around the $1.60 level in February.
U.S. production is going to increase
The President-elect of the United States ran on a platform of energy independence for the nation. Fewer regulations will result in a lower production cost for U.S. producers and crude oil will once again flow from the shale regions of the nation, particularly if the price moves north of $50 per barrel.
However, demand may also support a higher price for oil in 2017. Another pledge from the new President is to rebuild infrastructure in the country and that project will increase demand for all industrial commodities including energy. The incoming Treasury secretary expects the U.S. economy to grow at 3-4% in 2017 which will increase the demand for oil.
I have been writing that below $40 in crude oil capital expenditures dry up and above $50, U.S. crude begins to flow once again. However, it will be the demand side of the oil market that is likely to determine the path of least resistance for the price in the coming months. OPEC took the first step in fulfilling their mission to “stabilize” the price of petroleum and provide a “steady income to producers and a fair return on capital for those investing in the petroleum industry.” With OPEC production still above the level where it was two years ago, there could be room for additional cuts by the cartel in the future now that the Saudi’s have capitulated. Additionally, the upcoming IPO of Saudi Aramco means that a higher oil price is in the best interest of the Kingdom and they may be willing to consider additional cuts as they prepare to partially divest from reliance on oil revenues in the months ahead.
The Russia effect
Most analysts believed that an OPEC deal was a pipe dream. After all, the relationship between Saudi Arabia and Iran has been spiraling downward in recent years. The two nations continue to fight a proxy war in Yemen and the theocracy in Iran would like nothing more than to overthrow the Saudi Royal Family.
Iran’s influence in the Middle East has been on the rise since the nuclear non-proliferation deal and the country’s engagement with Russia in Syria has forged a close alliance. Meanwhile, while Iran’s power base has been rising Saudi Arabia’s has been declining. The Saudis traditional support from the United States has become questionable. The nation strongly opposed the U.S. deal with Iran and President-elect Trump said that the Saudis would have to start paying for U.S. military protection in the future. Additionally, the U.S. Congress overrode a Presidential veto on a piece of legislation that allows for U.S. citizens to sue the Kingdom of Saudi Arabia over losses sustained on September 11, 2001.
On Saturday, 11 non-OPEC countries agreed to reduce production by 558,000 barrels a day – 300K of that coming from Russia.
Following that announcement, Saudi oil minister Khalid al-Falih chimed in saying, “I can tell you with absolute certainty that effective Jan. 1 we’re going to cut and cut substantially to be below the level that we have committed to on Nov. 30.” He added that he was ready to cut below the psychologically significant level of 10M b/d, depending on market conditions.
Still, it’s unclear whether the historic deal will suffice to drain the oil stockpiles that have accumulated.
The Saudi’s have seen their monetary reserves fall over recent months as oil revenues declined with the price. As Russia is the other major oil producer in the world, Mr. Putin’s support of a production cut by the cartel put him in a unique position mediate between Iran and Saudi Arabia and to influence the Saudis to get a deal done.
While many may look at the oil market as the big winner if the price of the energy commodity continues to increase, and I think that is likely, it is the Russian leader that comes out of Vienna with a “historic victory”. As OPEC spoke on November 30, Vladimir Putin’s credibility on the world stage grew and his influence in the Middle East will reached a new high. The success of the production cut will result in the producing nations in the region owing a debt of gratitude to the Russian leader. The U.S. is also a winner as shale oil should start to flow again. The OPEC deal comes at a time when the world is preparing for a new beginning in the relationship between Russia and The U.S., perhaps it will be the era of Trump-Putin. In either case OPEC is Putinized, it could have important consequences for the price of oil as well as for the political power base in the Middle East for years to come.
By Vasko Nachev