Oil Markets Will Rebalance Only If OPEC Keeps Supply High

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Includes: DWTI, OIL, SCO, UCO, USO, UWTI
by: Options Trader

Summary

OPEC should pump at maximum capacity.

Increasing low-cost supply is necessary to weed out indebted unconventional producers and instill future financial discipline across the industry.

As supply of unconventional production fizzles, prices will stabilize in a higher range of $60-80 per barrel ensuring viability for remaining market participants.

My thesis runs counter to prevailing logic as most oil bulls believe OPEC should cut production for the price to find a sustainable floor and reverse the current downtrend. I will argue that sustainable price increases will only occur when OPEC pumps at max capacity and forces most higher-cost producers out.

I believe it would take OPEC approximately 12 months of $30 oil to force US production down 3 million barrels by the end of 2017 and bankrupt 70% of all higher-cost producers around the world. The supply destruction stemming from such a decision will have ripple effects for the next decade all the while keeping financial discipline in the oil markets.

Financial discipline is mostly an overlooked condition to keep industry away from historic price swings such that the oil market is experiencing right now. The root cause has been OPEC's reluctance to properly supply markets when prices were high for seven years since 2007. Faulty belief that unconventional production would never produce significant volumes lulled OPEC into inaction and false sense of market share security.

In the meantime, hundreds of smaller oil companies and service providers across the world went on a debt binge to increase capacity in unconventional production assuming OPEC's inaction is a static policy and not subject to revision since "maintaining price" is more important than "maintaining market share".

OPEC was indeed too complacent and failed to realize vast potential of debt-fueled unconventional production's expansion and thus waited too long to respond to this looming threat. I find it noteworthy, that once proper response by OPEC was made in fall of 2014, most unconventional producers thought of OPEC's new policy of "protecting market share" as bluff and kept pointing to various reasons, especially stressing fiscal breakevens of producing countries, as justification that OPEC may quickly back away and return to the previous status-quo.

Previous status-quo, of course, would have ensured that unconventional supply would become a permanent fixture of the overall market, but hundreds of smaller oil companies overplayed their hand and grew too fast and too far aided by unprecedented amount of debt. They did not proactively cut capex and production and now most of these companies are walking zombies. In the process they destroyed hundreds of billions of shareholder equity and are currently destroying hundreds of billions in bonds and bank debt.

In order not to repeat mistakes of the past, OPEC should keep markets well-supplied for an extended period of time for three reasons:

1) supply destruction among high-cost producers will lead to a balanced market for many years as capex cuts will ensure production does not grow for many years

2) instill financial discipline and create a strong precedent of wealth destruction when financial discipline fails

3) rid economies of their respective countries from resource-based parasitism as population sees that high oil prices are not permanent and other sources of revenue are necessary for wealth creation in the long-run.

As oil hovers around $30 per barrel many oil producing nations even within OPEC are no longer in position to make sufficient investments to keep production at current record levels. However, there is still large productive capacity in Iran and Iraq, which can come online rather quickly to stave off declines from some of the weaker members of OPEC. "Adequate" supply (a term used by Saudi Arabia) can be sustained long enough to achieve necessary market rebalancing.

As OPEC keeps supplied steady for another two years, unconventional production landscape will be forever changed due to numerous bankruptcies and force financial discipline across the entire specter from producers to investors. Growth in unconventional production will no longer be predicated on debt, which means there will be no growth at all until oil prices climb above $70 per barrel and stay there for a significant amount of time.

Even then the rate of growth will be miniscule as investors/lenders will be cautious to avoid excessive financing of unconventional producers as painful events of the current bust will dominate group thinking. Financial engineering and investor slide decks work until reality sets in, which is where geology and physics take precedence. Decline in existing fields along with mass exodus of new investment from unconventional plays will ensure a stable oil price for the foreseeable future. In order to achieve this, OPEC should just keep on pumping.

Disclosure: I am/we are short DWTI.

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.