OPEC: Too Little, Too Late

In March of 1974, in the midst of the oil-dependent world’s first oil shock, economist and Nobel Laureate Milton Friedman noted:

Higher [oil] prices induced consumers to economize and other producers to step up output… In order to keep prices up, the Arabs would have to curtail their output to zero… Well before that point the cartel would collapse.

Jump ahead 24 years and we’re going through it all over again.

A few days ago OPEC’s president warned “severe” cuts were on their way.

“Severe!” The markets seemed shocked. What did “severe” mean? Oil prices went back on the climb. Many traders were thinking, “Maybe this time would really be different and OPEC’s members would all work together.”

Yesterday, we learned it was all for naught. “Severe” turned out to mean a mere 2.2 million barrels per day (bpd) cut.

Another record - the biggest production cut in the cartel’s history - but nothing like the 3 or 4 million bpd the market was expecting. As you might imagine, oil prices collapsed 8% in practically no time and traded under $40 a barrel for the first time since 2004.

Race to the Bottom

Don’t get me wrong, a 2.2 million bpd cut is something. It just would’ve been something worth worrying about two months ago. Now, it’s a much different story. Combine steady declines in oil consumption around the world along with OPEC’s cheating ways (as a whole OPEC has produced between 1.5 and 2 million bpd over the agreed upon quota over the past few years - depending on the source), a 2.2 million bpd cut may not have any real impact on oil prices for a long time to come.

But here we are. Merrill Lynch (MER) recently predicted oil is going to $25 a barrel. Goldman Sachs (GS), which has just called for $200 oil a few months ago, also predicted $25 a barrel.

It’s a tough time to be an oil investor. If you’ve held out and decided to ride out the storm (I wished you would have been a reader earlier) or if you’re looking to buy oil, there’s a lot of uncertainty.

Has oil finally hit bottom? Has the first half of a giant “V” formed in the oil price charts? How much capital investment will really be cut? How long will this window to get in on oil stay open?

As always, if you look beyond the headlines, there will be answers and we’ll be able to be certain when others are uncertain (which is usually a pretty profitable place to be when it comes to investing).

Oil in the Short-Term

Now, I don’t know where oil is going over the next few days or weeks. There are just too many variables. The trend is down and at this point not too many people are ruling out $30 or even $20 oil if the global economy takes another turn for the worse.

Here’s the thing though. The stock market is actually a very good predictor of oil prices. Oil service stocks (Oil Service HOLDRS ETF - OIH) have tended to lead oil prices (U.S. Oil Trust - USO) for the past few years. When oil service stocks went up, oil prices have followed. When oil service stocks went down, oil prices followed.

As you can see in the chart below, oil service stocks have consistently led the way. Whichever way the OIH (gold line) went, USO (blue line) followed.

click to enlarge

Take a look at September 2006, the OIH crossed above USO. Three months later oil prices followed suit.

Last summer the USO crossed over the OIH and oil prices started to get a bit out of control. Oil prices were running, but the oil service stocks weren’t going with them. Clearly there wasn’t much expectation in the markets for oil prices to stay at such lofty highs. Again, about three months after the crossover, oil prices started falling just like oil service stocks had been anticipating.

Now, oil and oil service stocks are at an impasse. If we see oil service stocks continue to climb, it’d be a safe bet oil prices will follow right along behind them in about three months time.

That’s why I suspect OPEC might get its wishes for oil prices to rise over the next few months. Whether OPEC’s cuts (or the OPEC members actually sticking to their quotas), an economic recovery, or something else altogether bumps up oil prices, a short-term run-up in oil prices is a very real possibility.

For my money though, I’ll keep an eye on the oil service stocks. They’ve proven over the past few years they’re much better at predicting the next move for oil than any OPEC leaders or analyst. Still though, OPEC always could be a factor.

Thinking Again

Time and time again, OPEC proves no one believes in them. After decades of cheating and failing to stick to agreed upon quotas, no one expects them to this time.

As we discussed a few weeks ago right after OPEC’s “pre-meeting” meeting, OPEC is “functional” at best when oil prices are high. When oil prices are low (and/or falling) the cartel just doesn’t work. In Oil’s Slippery Slope, we went as far as stating, “If you think OPEC is going to be able to keep oil prices propped up… think again.”

Now that oil prices have dropped another 20% since then (the drop would be closer to 30% if it weren’t for a 10% decline in the U.S. dollar over the same time period) we see how truly futile OPEC is against market forces. They can put on a great show and invite friends like Russia to the party, but OPEC can’t single-handedly keep oil prices propped up.

Where to From Here

From here, oil has got a long way to go back to its previous highs. There’s a lot of extra capacity out there and it can be turned back on relatively quickly. OPEC has cut more than 4 million barrels per day of production, which will come quickly back online if oil prices rise.

But for those of us with a long-term outlook (5 years or more), there will be some good gains to be had in oil. The long-term picture hasn’t changed much and the big oil consumers of the world are still making moves.

China knows oil will be scarce once again and is continuing to secure oil reserves and production capacity. A few days ago China Petrochemical Corporation received government approval to move forward with its $1.5 billion takeover of Tanganyika Oil [TSX:TYK]. The takeover will increase CNPC’s annual production by about 2%.

It doesn’t stop there. China is interested in offering $130 million for Urals Energy [LSE:UEN] according to Chinaknowledge.com. The deal, if completed for the price, would mark a 400% premium over Urals’ current market cap. Also, Canada’s Financial Post reported China National Petroleum has been sniffing around Verenex Energy [TSX:VNX] and could be in play as part of a $300 million deal.

It’s not just China getting ready, India’s right there too. India’s national oil companies (NOC) have set aside a total of $3 billion to secure new oil projects during the downturn. India is still upping the ante. The fast-growing nation has offered to build and pay for refineries and pipelines for prospective oil fields in Nigeria, Libya, and Turkey.

The Rich Get Richer

Clearly there’s still some interest in oil companies from certain parties. And from current levels, oil could realistically fall back to a $20 to $30 price range. After all, a lot of commodities have already reverted back to 2002 lows and it's possible oil could fall right back there with them.

The distant future is bright for oil and it’s probably safe to start slowly wading into oil stocks again, but to go “all in” now could be a big mistake.

With OPEC still putting up a fight and oil traders willing to bid up oil in anticipation, OPEC can actually work together with traders. I still think that it just doesn’t feel like we’re at absolute, rock-bottom yet.

Oil certainly looks a lot better here than it did a month ago, but there are potentially much better opportunities in trading undervalued bonds or playing a convergence of the XAU/Gold ratio.

Comments

[Ishortyou:]

Nah...personally and I think I represent a portion of the american consumer will not buy a car that uses fossile fuel, it gives me a lot of headaches to be honest and not only from the pollution.

2008 Dec 19 07:32 AM

[Tim H.:]

I agree with poster. Oil was a Bubble play just like tech in 90's, real estate afterwards and commodities especially oil were next bubble. I agree oil going forward is becoming scarcer and harder to find. Not to mention more expensive to find. BUT the consumer won't forget what happened last couple years with the outrageous futures traders play on oil. Plus you have a new Presidential administration who see's "green tech" as a way to get this country's economy back out of a recession and create jobs. In fact I believe the next market bubble will be green tech. With energy efficiency which creates more money in consumers pockets and less dependence on foreign oil which funds terrorists. Oil prices will stabilize but I am not seeing another boon anytime soon. I put my money where my mouth is in that have investments in wind & solar.

2008 Dec 19 08:26 AM

[Marcus Aure...:]

Ishortyou, you represent only you. I am not buying a car because we have the two we need, I buy used, and grew up in a household that runs the wheels off of their cars. When the wheels fall of one of our cars we will buy another gasoline powered vehicle, unless the alternative is both practical and affordable. Right now, alternatives are neither.

I believe the oil rally of summer '08 was a tech/speculative rally. The situation was like a spring with a lot of tension, when it lets go it recoils and does not stop until it is way past its natural point of equilibrium.

Where are we in relation to the equilibrium point? Well US oil stocks are high in relation to the five year average and dropped only by a little bit in the last week or so and we have Thunder Horse ramping up to be in full production within two years. However, we do have the economic downturn going on. My wife's nephew is a sailor and tells us six of his company's ships are docked - not enough material coming from China to the US.

Right now we are still above equilibrium, but when economies starting recovering watch out.

2008 Dec 19 12:27 PM

[Socialism c...:]

Peak oil is here, and prices will NOT stay this low for much longer. One needs only look at what Shell is doing to realize this -- they are buying up oil at sub-40 per barrel prices to store for sale/use later. It's so cheap they are better off doing this than extracting their own at the moment.

2008 Dec 19 12:37 PM

[Chris B:]

Green investment is absolutely necessary, but there is no way it will replace oil consumption in the next 5 years. All those SUV's we loaded up on in the last 5 years will still be driving long commutes 5 years from now back and forth from all those far-flung suburbs and exurbs we built at the same time. They will still be affordable as used cars because of massive depreciation and low insurance rates due to their low values.

Wind and solar will likely displace new coal, gas, or oil fired generation facilities, but unless people start scrapping, not selling, their running low-mileage gas guzzlers and buying new small cars, oil demand isn't going anywhere in the US. Advocating a $1-$2 gasoline tax in this country is seen as pure madness by the same people who are building up our massive intergenerational debt.

2008 Dec 19 12:50 PM

[Proud to be...:]

What people continue to leave out of all of these articles is the geopolitical instability in the region and how most of the OPEC countries plus Russia are "frienenemies" at best. What happened when Russia invaded Georgia? Prices ticked up. Same with the Hizballah/Lebanon war. Once the global downturn ends, the supply and demand of crude will be the same as it was when oil was $150/barrel. Combine that with an international incident here and there to spike the price every once in a while and $35/barrel oil seems like a great intermediate range investment to me.

2008 Dec 19 06:10 PM

[Ron2008:]

Why on earth isn't the US gov buying oil now when it is less than $40 for the SPR? They had no trouble buying oil for the SPR when it was $120+.

2008 Dec 20 09:15 AM

[Ames Tiedeman:]

Oil is in the process of bottoming and will be substantially higher 6 months from now.

The world is not ending.

2008 Dec 20 11:54 AM

[Ames Tiedeman:]

Ron, I agree. We should build a second strategic reserve at these low prices..

2008 Dec 20 11:55 AM

[James Brumley:]

Yep, there's no better cure for high prices than high prices themselves.

2008 Dec 21 12:30 AM

[Kunst:]

"Goldman Sachs (GS), which has just called for $200 oil a few months ago, also predicted $25 a barrel."

Flip that coin again. Maybe it will come up 200 this time.

2008 Dec 21 12:30 PM

[Teutonic Kn...:]

I agree with the author that the foreign oil producers are in trouble and they are behind the curve in realizing their precarious situation.

Just common sense observation. When oil was trading around $140/barrel a few months ago, and now around $30-40/barrel, the effect would be devastating akin to an American household that suddenly finds its monthly take home check cut from $1400/month to $35/month. Worse still, the pain would be felt greater if that household had adopted a spending habit predicated on a $140/month paycheck.

To make matter even worse, and the pain greater, many of the oil exporting countries' economies are not diversified and oil is the single most important income. Note that oil cannot be easily and readily massively stockpiled and are traded on a daily basis in the open market. It boils down the how long and how severe this Recession/Depression is going to go. Cutting production also cuts income.

It is interesting to see how this round is going to play out in the next two to three years.

2008 Dec 21 07:00 PM

[Oregonrain:]

I happen to agree that it is the time to add a steep energy tax to in part begin to dig ourselves out of the enormous debt we have now. In addition, it will act as a drag on energy consumption. When this is implemented is important. Not now....

2008 Dec 21 08:28 PM

[bythenumbers:]

I'm not sure where the author came up with the idea that OIH is a leading indicator of USO. By looking at the adjusted closing prices in detail (normalizing them and charting them together at various turning points), it's apparent that just the opposite is true. USO is a leading indicator for OIH by a couple of days at a minimum.

2008 Dec 22 12:47 AM