OPEC's Devastating Miscalculation That's Crushing The Oil Market

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Includes: OIL, USO
by: Gary Bourgeault

Summary

Reasons why OPEC missed so widely with its supply increase strategy.

The two things U.S. shale companies surprised them with.

Why the huge mistake is so difficult to fix.

What the future for oil holds.

Source: Stock photo.

As more eyes focus on the cause of the plunge in the price of oil, Saudi Arabia and OPEC are trying to change the narrative, giving the appearance they aren't the cause of the problem, even though it decided to let the oil flow to attempt to crush the shale industry, temporarily maintain market share, and buy time to make changes to its government budget in order to slow down the shrinkage of its reserves.

The cartel made some major miscalculations concerning the state of the overall oil sector, as well as the ability of many shale companies to endure its competitive assault. That has left OPEC is a difficult situation because it has brought to light the fact it isn't as powerful as it used to be, and is no longer a united entity.

What I see as the major issue is OPEC misunderstood the oil industry was going through a period of significant disruption. Its response was the same it has made in the past when it took steps to rebalance the market and keep market share where it wanted it. Because of that, it has made things much worse and created more problems for the sector and itself. It'll take some time to work through them and discover what the end-game will be under the new conditions.

Big miscalculations

Where OPEC and Saudi Arabia missed in its analysis of the situation was that this was a disruption and not a supply cycle that had occasionally occurred in the past. This is the major reason the medicine it attempted to apply didn't work, and still isn't working.

This isn't about a simple rebalancing, but about a new oil source that, for the next several decades, will bring much more supply to the market. Not too long ago this wasn't even considered to be part of the competitive landscape.

The U.S. shale industry itself, when combined with the other oil resources, has resulted in the country being able to produce at the same levels Saudi Arabia and Russia are able to.

With the U.S. having between 70 billion to 80 billion barrels of recoverable shale oil, and the rest of the world about 350 billion barrels more, shale is just getting started in the impact it'll have on the market.

OPEC overrated its ability to stop this and underrated the resourcefulness of the U.S. shale industry in dealing with the offensive measures it took against it.

Where shale companies surprised the cartel

Beyond the disastrous assumption this was only another supply cycle issue, the mistake in its strategy as it relates to U.S. shale companies was the hedge protections in place and their ability to reduce costs to become profitable at lower price points.

Those shale producers that will survive and thrive in the future will be those that have been successful at lowering the cost basis for profitability. This is because much of the hedging that helped them in 2015 will, for the most part, be gone.

According to Lukoil vice-president Leonid Fedun, in 2015 approximately 50 percent of shale production in the U.S. was hedged, providing a subsidy of about $150 million a day for the industry. He added that many of these hedges are quickly expiring, and for 2016, only about 11 percent of U.S. shale production will be hedged.

This will probably result in a lot of the smaller players and higher-cost shale producers to declare bankruptcy in 2016 or sell its assets at bargain prices to larger companies with solid balance sheets, healthy free cash flow and access to the credit markets.

How long all of this will take to play out is the major question now. The oil sector has never experienced anything quite like this, and it's not a certainly there will be a reversal in direction in the near future, as some think there will be.

Why it's so difficult to fix the supply and price debacle

Now that the pressure on the price of oil has going on for about 18 months, it confirms the way out of the mess isn't as easy to solve as it would appear to be. Again, that's because this isn't about a supply cycle but about an industry disruption.

A lot of the reason for the difficulty is OPEC has revealed itself to be highly incompetent in its interpretation of and reaction to market conditions, and now is trying to figure out how to move forward without adding to the problem and further weaken the brand and its pocketbook. This is especially true with Saudi Arabia.

OPEC has revealed itself to be only a weak shadow of its former past, and it can't even seriously be considered a cohesive unit in any way. This is a weakness that could be exploited by competitors outside the cartel by putting pressure on some of the countries that are extremely dissatisfied with how they're being treated because of the decision to keep supply flooding the market.

Just like individual shale companies, OPEC countries have varying price points determining profitability, and what works okay for some is devastating to others. Further, there is no attempt to even try to hide the fact this has made the cartel even more fragmented than it had been.

Another reason this is difficult to fix is Saudi Arabia has made a lot more enemies because of its decision to have OPEC take these steps. Not only has it made it a lot worse for Russia, but during the same time it is trying to move into markets Russia has supplied for year in Europe, and take share away from it. The devastation to many U.S. shale companies is well documented as well.

This doesn't include the ongoing and increasing tensions between Iran and Saudi Arabia within OPEC, making it extremely hard to even come to the table and talk about a solution, let alone implement one.

Looking ahead

Saudi Arabia has attempted to push forward the narrative that increasing demand will rebalance the market, suggesting competitors won't have to do much over the duration of the low-price environment because of market demand. It's also wrong about this.

Major oil consumer China has already had its demand for 2016 downwardly revised, and the rest of the world economies are under pressure. This isn't conducive to a environment where demand for oil will significantly grow in.

What does Saudi Arabia mean by this? It's basically saying it has no intention of lowering supply to the market, and neither is OPEC. It has stated such by saying if all the major producers won't come together and agree to cuts, it won't make cuts.

This is disingenuous because Saudi Arabia and OPEC is what caused the problem, and now it wants production cuts from all market competitors in order to support the price of oil. Interpretation: The cartel made a huge mistake and it wants the rest of the market to help cover it up by agreeing to supply cuts. I would be surprised to see this happen. It would be a form of manipulation which would result in OPEC moving back into a predominate and controlling position. It would be like the shale industry agreeing to be put back in the bottle once it escaped.

Conclusion

Even though Saudi Arabia in particular has tried to remove the stigma of its disastrous mistakes by press releases and clouding the issue, it isn't working, and as it relates to investors, it has put itself into a corner that leave little if any options other than continuing on with its oversupplying of the market and hope demand will grow enough over the next several years so it doesn't have to obliterate its domestic budget.

It has already taken steps to shrink the size of its government, but this is only the beginning as it faces an oil market that has an addition 419 billion barrels of recoverable shale oil, and more to be added as exploration and investment increase.

Many U.S. shale companies have also learned to tap into their strongest oil deposits at a low price, which will offset some of the hedges being lost in 2016.

Be extremely wary of making any investment decisions on the news OPEC and non-OPEC countries are ready to enter into negotiations concerning production cutbacks. Not only has Iran rejected such an idea, but a new player that has been very vocal lately has been Iraq, which has clearly stated it not only has not interest in cutting supply, but will probably increase it in 2016. Libya is also trying to bring its two major combatants together in order to boost production in the near term. I could go on.

There isn't going to be any agreement, and some expected cuts in production from U.S. shale isn't going to offset the existing production, nor the added supply for the rest of the year. Thanks Saudi Arabia.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.