Oil Freeze - You're Busted

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Includes: BGR, BNO, DBO, DDG, DIG, DNO, DRIP, DTO, DUG, DWTI, ERX, ERY, FENY, FIF, FXN, GUSH, IEO, IYE, NDP, OIH, OIL, OLEM, OLO, PXE, PXJ, RYE, SCO, SZO, UCO, UGA, USL, USO, UWTI, VDE, XLE, XOP
by: Andrew Hecht

Summary

OPEC and Russia.

Freeze is another way of saying keeping pumping.

Why the cut will eventually come.

Does Russia now run OPEC?

Iran holds the key.

Crude oil has been on a very rough road over the past year and a half. The price has moved from over $100 per barrel to lows of just over $26, before bouncing a bit. OPEC, the oil cartel, has been very quiet during the rout in petroleum prices. The cartel meets, officially, twice each year. After the past three meetings, the price of crude oil made new lows. OPEC has done nothing to stand in front of the crude oil bear; in fact, the cartel has actually exacerbated selling in the oil market. As the price has moved lower, members have sold more crude in order to capture revenue. Sanctions recently came off one important cartel member, Iran. This has resulted in even more selling hitting the market.

OPEC's philosophy has been that a lower crude oil price will force shale producers in the United States out of the market, eventually resulting in higher market share for cartel members. While rig counts in the U.S. have dropped precipitously over the last year and a half, production remains strong in America. The U.S. continues to pump over 9 million barrels of crude oil each day. Last week, we may have heard the first signs of some action from the cartel. Interestingly, one of the players involved in strategic initiatives is not even a member of OPEC.

OPEC and Russia

OPEC produced over 32 million barrels of crude oil in January. The largest producer within the cartel is Saudi Arabia, with over 10 million barrels per day of output. The second-largest producer in the world is a non-OPEC nation, Russia. The Russians also produce over 10 million barrels of crude each day.

Iran is an important member of the cartel. Given the recent nuclear non-proliferation agreement between the West and Iran, sanctions have eased and Iran is now producing more oil. The release of funds, some $150 billion as part of the agreement, has given Iran new influence in the region. That influence is both political and economic. Iran has maintained close ties with Russia and the Putin government. Both are fighting on the same side in Syria. At the same time, relations between Iran and Saudi Arabia have deteriorated. A proxy war in Yemen, which borders on the Saudi Kingdom, pits Sunni forces backed by the Saudis against Shiite rebels backed by Iran. The two nations remain the most powerful within OPEC and the region.

While the relations within OPEC have deteriorated, Russia has moved into a position as mediator between the two most powerful cartel members. Russia's oil production as well as its ties and common goals in the region have put the country in a key diplomatic position when it comes to the Saudis and Iran.

As a testament to its newfound role as arbiter of disputes and long-standing hatred between the two OPEC nations, Russia was able to arrange the first step last week in terms of some action to combat the falling price of petroleum. OPEC has not been able to agree on anything over the last two years as the price of oil fell. The only thing that came out of the biannual meetings was an agreement to keep pumping. The common enemy has been U.S. shale production, which the cartel swore to push out of the market via lower price. The rationale of the OPEC members has been to build market share for the future.

Now, Russia seems to have gained a great deal of influence within the cartel by virtue of its production and political interest in the region.

Freeze is another way of saying keeping pumping

In a meeting between the Saudi oil minister and his Russian counterpart with Venezuelan and Qatari representatives present, a "freeze" in production at January 2016 levels was discussed. The attendees were an interesting mix. The Saudis have long been the richest members of the cartel and Venezuela the poorest. Qatar has been a neutral state in terms of the conflict between the Saudis and Iran. The makeup of the meeting represented a broad inclusion of the existing political landscape within OPEC. Iran was quick to comment that it would abide by a freeze - which was likely a predetermined notion that the Russians went into the meeting with in their pocket. It is in the best interest of all parties that the price of oil rises. However, sworn enemies Iran and Saudi Arabia are not likely to come to agreement on anything given the current strains between the two nations on a number of issues without outside help.

At first blush, a "freeze" looks like a real nothing in terms of a cure for low oil prices. It appears to be a prescription for all parties to keep pumping. Last year, the unofficial ceiling on OPEC production was 30 million barrels per day. In January, the cartel was selling over 32 million barrels, with prospects of more output given Iran's statement that it is the country's sovereign right to sell more. Additionally, cheating by other members continues to increase the daily output from members. As the price has moved lower, the poorer nations have sold more to capture as much revenue as possible. After all, it now takes around three and a half barrels of crude oil to create revenue that one barrel yielded just two years ago. A "freeze" only means lots of oil continuing to flow into a market in a world where inventories are building and the globe is awash in crude. One only has to look at the current state of the forward curve in crude oil to see the effects of massive production.

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U.S. inventories remain north of 500 million barrels ex the SPR. As the daily chart of the March 2016 versus March 2017 crude oil spread highlights, contango at around $10 per barrel on one-year NYMEX crude oil spreads translated to over 30%. Brent spreads are also wide, reflective of huge supplies. Therefore, a freeze is just another way of saying that OPEC will keep pumping, for now.

Why the cut will eventually come

The international world of crude oil is a business that transcends economics. Politics plays a major role in the direction of price. The rapid disintegration of the price of the energy commodity has put pressure on the members of the cartel, rich and poor alike. The rich members, the Saudis and other Gulf states, have seen revenues fall. Saudi Arabia began borrowing money in the public debt markets for the first time in many years recently. It has raised domestic energy prices and cut back on social programs, and has even discussed raising money by selling a piece of the Kingdom's crown jewel, Aramco, in an initial public offering. At the same time, the Saudis have had to deal with an increasing military budget as the proxy war with Iran in Yemen continues to rage. They have also realized that expenditures for protection of their borders and homeland need to increase due to aggression from Iran and terrorist factions in the region. The lower price of oil comes at a very bad time for the Saudis and their allies in the region.

Meanwhile, poor members of OPEC, like Nigeria, Venezuela, Angola, Algeria, Ecuador and others, have really taken a hit with oil prices. Weak economic conditions and lower revenues from the energy commodity in these countries have caused them to lobby and clamor for a production cut. Lower oil means less foreign investment in their nations for the extraction of the energy commodity by companies involved in the petroleum business that are much less rich these days. This all adds up to rising support and a realization that the only way to deal with the falling price of oil is to resort to the economics of supply and demand. When prices fall to a level where production becomes uneconomic, production tends to decrease. Therefore, a production cut by the cartel that holds more than half the world's reserves within its borders and supplies the world with massive quantities of the resource is becoming more likely each day.

Does Russia now run OPEC?

Russia is in the same boat as many of the OPEC members. Its economy is in bad shape - the result of sanctions from the West over Ukraine and lower raw material prices on which the commodity-rich nation depends for revenue. Therefore, Russia has a stake in the price of oil and the action of OPEC. Given their close ties to Iran and their military might, the Russians have been inserting themselves into the OPEC equation. Last week's meeting and "freeze" was a sign that Putin's Russia is getting more involved in global oil policy by taking a role, albeit an advisory one, with regard to the cartel.

Given Russia's relationship with Iran, a nation with newfound riches in the form of $150 billion from the recent agreement, Russia stands to benefit the most. Iran is purchasing military equipment and technology to bolster its fighting forces from the Russians. At the same time, in a quid pro quo move, Russia has forged ties with the nation so that it can exert increasing influence in the Middle East. This has made Iran a "front man" for Russia in terms of the cartel. If you think about it, a combination of Russian and Iranian daily crude oil production makes the two nations the number one producer in the world, surpassing the Saudis. That gives this alliance a lot of power in terms of OPEC policy. As a non-member of OPEC, Russia has now put itself in a position where it can become the most influential power over the cartel.

Iran holds the key

The crude oil business is an international chess game. The continuing conflict in the Middle East has been so important to the world because of the massive reserves of petroleum that reside in the region. War and oil have gone hand in hand for decades.

Iran was a pariah nation since the late 1970s, when the Islamic Revolution caused the world to shun the nation. The recent agreement with Iran results in a new era of power and influence for the nation. Iran, as a petroleum producer, has suffered from lower oil prices along with its fellow member nations in OPEC. However, Iran received something none of the others did over recent months. The release of $150 billion has been a cash injection at a time when other oil producers and neighbors in the region are bleeding. This puts the country in a position of power from an economic and political standpoint. Its alliance with Russia has further bolstered influence given the military prowess and position of Vladimir Putin, who, like the theocratic leaders of Iran, calls all the shots.

While many discount any notion of a "freeze" in production discussed last week with the aid of the Russians, those who remain short the oil market could be in for a surprise. It could be a case of freeze - you're busted if a coordinated production cut comes soon. Russia is likely working toward that goal, and catching the world by surprise would yield explosive results for the price of crude oil.

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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.