Market's Bizarre Response To Iran's 'Support' Of Proposed Oil Production Freeze By Competitors

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Includes: EOG
by: Gary Bourgeault

Summary

There is no production freeze agreement in place - it remains a proposal.

Iran and Iraq must agree to freeze production as well. It isn't going to happen.

Iran has already said it will boost production until it reaches pre-sanction levels.

It's disingenuous to call this a departure from past policies when Russia and Saudi Arabia are supplying oil at high levels.

The narrative surrounding the attempted manipulation of the price of oil by major producers is getting stranger, as the latest catalyst to support oil has been Iran saying it's okay with a production freeze on the part of its major competitors like Saudi Arabia and Russia. Why wouldn't it be, it's just starting to boost production after having sanctions being recently lifted against it.

Already the production freeze, which is only a nice idea at this time because it's predicated upon Iran and Iraq agreeing to do the same, has participants backpedaling and suggesting Iran now won't have to adhere to the agreement.

So here's where it stands as I write. Russia is now producing at its highest level since the collapse of the Soviet Union. Saudi Arabia is also producing at very high levels. And now that they're at those levels they're pushing for an agreement to freeze production. Not only that, but Iran is being offered an exemption in order to increase production to its pre-sanction level, which is about 2 million more barrels per day. This is what has the market all excited and pushing up the price of oil. It's insane. All it does is lock in existing oversupply and allow Iran to add to it.

In other words, Saudi Arabia and Russia are giving up nothing, and Iraq, the other major player, is producing at record levels as well, and would lose nothing if it agreed to the terms of this proposal. Iraq is producing at these levels in order to generate revenue to fight its war against ISIS. Does anyone seriously think it's going to capitulate and lower production at the risk of losing more of the country to its enemy?

Since the caveat was that Iraq and Iran would have to come on board in order for this to work, I don't get what the market is responding to. By the terms of the proposal, it has already been rejected. Yet the media are reporting this as a positive move toward a future potential future cut in production. This at a time when Iran has unequivocally rejected any type of cut until it returns to the production levels it has targeted.

It doesn't matter if there was a legitimate freeze or not by countries outside of Iran, when you consider demand growth has been downwardly revised and Iran is going to add even more supply to the market over the next couple of years at least.

We also know the U.S., China and Canada will have no part in this proposal, so once again, it's nothing more than a propaganda effort to create the illusion of progress toward a deal ending with a reduction in oil supply. All these meetings represent are staged media events disguised as serious efforts to solve the oil glut, but in reality are coordinated strategies to create photo ops and material for press releases. They obviously do nothing to deal with the oversupply of oil to the market.

(click to enlarge) source: USNews Click to enlarge

Russia and Saudi Arabia

It's worth looking at the production levels of Russia and Saudi Arabia, because they reinforce my thesis this is nothing more than a proposal to influence the media.

As mentioned above, Russia is now producing at record levels since the breaking up of the Soviet Union. So when it has agreed to freeze production levels, what is it offering the market and competitors that make a real difference? The answer of course is nothing. Ramping up production to levels to the point it has reached near capacity levels, and then parrot the idea it is now ready to freeze production in order to support the price of oil, is deceitful.

The same goes for Saudi Arabia. While it has allegedly recently cut back on production from about 10.5 million barrels a day to close to 10.2 million barrels a day, it won't struggle at that level to retain its market share over the next year.

What this says is nothing has been offered at all by these two oil giants. It's concerning to me to see the financial media report this as a serious effort to provide support to the price of oil. Investors believing this is a legitimate effort could once again get crushed once the market absorbs the proposed deal and realizes there's absolutely no substance to it.

Iran already offsets any production freeze

Even if this proposed deal were to eventually become a reality, and Iran wasn't going to boost production, I would still say it was meaningless as it relates to supply and demand, because at current levels, even without Iran supply increases, supply would far outstrip demand.

Add to that another 500,000 barrels per day to 1 million barrels per day over the next 12 months or so, and another 1 million barrels per day further out - depending on how long it takes Iran to increase production to that level - and it already undermines the supposed reason for the freeze in the first place.

Either this is a production freeze or it isn't a production freeze. There can't be an exception for Iran and still call it a freeze. The reason there is an exemption being suggested is because Saudi Arabia has no influence on Iran, and if it wasn't offered it would be more obvious than it already is. That's significant because those outside of the industry aren't as familiar with the waning unity and power that was once represented by OPEC, as those within or following the industry are. Knowing that, especially in regions prone to unrest, could make things worse if people started to believe repercussions from the loss of oil revenue were worse than they understood it to be.

Investors have to take as a fact Iran is not going to agree to any freeze or cut in production. That alone makes the rest of this smoke and mirrors. Locking in supply at a level that still surpasses demand isn't a policy, it's an insult to our intelligence.

The inevitable response from U.S. shale producers

Under the best-case scenario, where the market is convinced this will lead to production cuts that will be adhered to and are verifiable, the price of oil would without a doubt start to climb once again. That brings us back to what has forced competitors to reach this point in the first place, which is the emergence of the U.S. shale industry. The introduction of oil produced from shale has been what disrupted the oil market in the first place, and will continue to disrupt it for decades.

With many shale producers having to declare bankruptcy, it has given the impression the industry has been severely damaged. The truth is only the weaker producers have been damaged, and those that have strong management teams in place have boosted efficiency, lowered costs, and found ways to increase production at operating wells while developing drilled but uncompleted wells to bring into production when the price of oil rises once again.

Some producers such as EOG Resources (NYSE:EOG) have stated they can make money at $40 per barrel. If other U.S. shale producers are also close to that level, it means they're likely to bring the thousands of DUC wells in the U.S. into production if the price of oil gets close to that mark. With the inclusion of shale oil and Iranian oil production increases, what value or impact does a deal to freeze oil production at or near record levels even have?

Conclusion

There has been a lot of talk about reducing the volatility of the price of oil. The problem is interfering in the market, like Russia and Saudi Arabia are attempting, is to make it worse rather than better. The genius of a free market is the ability to find what the price of something is worth. Attempts to bypass that and control the price never ends up well. History has proven that time and time again when price controls are put in place. This is obviously different than that, but non-market forces trying to prop up a price beyond what the market is revealing will produce more, not less volatility.

For example, even though the price of oil has jumped in response to the proposed production freeze, it will without a doubt come crashing down once again. There are only so many times the market will endure these assertions about cuts in production, before it punishes the lie for what it is. The punishment will come in the form of downward pressure on the price of oil to reflect the actual market conditions.

Another important element investors aren't considering is we still have an enormous amount of inventory that has to be worked through, and that will increase on a daily basis, even if a production freeze were agreed to. Nothing but a significant cut in production would change that, and if that were to happen, all the high-cost producers would ramp up supply to boost earnings.

I've been saying for a long time this is the catch-22 the oil industry faces, and nothing being offered as a solution, specifically a production freeze, does nothing to address it. Be prepared for another significant drop in the price of oil.

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.