Wednesday's sudden jump in oil prices caught most traders off guard. While all traders were aware that OPEC was holding a meeting in Algiers, few actually believed that this dysfunctional cartel of oil producers, whose members have a long history of violating their promised production limits, would actually reach a consensus. Because two key OPEC members, Saudi Arabia and Iran, have been at odds on so many issues, including the global Sunni-Shia conflict, it seemed nothing more than wishful thinking that they might reach an agreement on the lunch menu let alone on anything else. So as soon as the media reported rumors that a production agreement may have been finalized, oil prices immediately spiked.
I have been bullish on oil for some time, admittedly too soon. However, my bullishness was based on a number of factors, including the continuing growth in demand. Most importantly, however, I was convinced that low oil prices would eventually prove too painful for the major producing nations to bear.
Keep in mind that there are many oil producers in the world, yet there are only three that really matter. These are the United States, Russia, and Saudi Arabia. These three are the biggest producers by far. China is a distant fourth.
The U.S. is unique, at least when compared to Russia and Saudi Arabia. That's because in addition to being a major producer, the U.S. is also a huge consumer. In fact, the U.S. is the world's largest consumer, gobbling up about twice as much oil as it produces. As a result, low oil prices are a net benefit for the U.S. economy. Low oil prices are certainly painful for Americans working in the oil industry, but they're money in the bank for consumers.
Things are very different in Russia and Saudi Arabia. With their incursions into Ukraine and Syria, the Russians find themselves extremely stretched financially. The Russians, led by President Vladimir Putin, require much higher oil prices to fuel their aspirations for global domination - or at the very least domination of the near-abroad. When it comes to the comforts of daily life, the Russians are happy to do without. Perhaps no people on Earth can endure suffering as well as the Russians can. But when it comes to the military, any talk of sacrifice is off the table.
As for the Saudis, they have a long history of subsidizing just about everything for their citizenry. This includes utilities, gasoline, education, and healthcare. Many Saudis find themselves in no-work jobs. The government pays them simply to show up. Saudi Arabia is also full of foreign workers. But low oil prices have wreaked havoc on the Saudi economy and many foreigners have been laid off yet have no way of returning home. The Kingdom has tapped into its foreign reserves and it has cut back on the generous handouts. While low oil prices are a net benefit for Americans, they have proved extremely painful for the Russians and Saudis.
As a result, while Russia and Saudi Arabia exhibited a tremendous ability to tolerate the pain, it seemed clear to me that they could not hold out indefinitely. Eventually, they would have to at least begin speaking with one another about cutting production. That's exactly what happened just a few weeks ago. Of course, they failed to reach an agreement, but they did meet with one another. That in itself was a big deal because these two nations find themselves on opposite sides in several geopolitical conflicts, not the least of which is Syria.
The latest news is that OPEC members reached an agreement to cut total daily production by as much as 700,000 barrels per day. Russia is not an OPEC member so it wasn't a party to the deal, and 700,000 barrels is not a particularly large amount. Yet as they say, "It's the thought that counts." That thought was strong enough to cause a near 5% rally in oil prices.
It's a big deal when the Russians and Saudis agree on anything. It's an even bigger deal when the Saudis and Iranians agree on something. Due to sanctions, Iran's oil has been off the world market for some time. Iran has been insisting on its right to increase production to pre-sanction levels, something Saudi Arabia has vehemently opposed. If it is true that a deal has been struck in Algiers, either Saudi Arabia or Iran (perhaps both) must have made some major concessions. Whatever the case, I'm enjoying the rally in my largest oil-related positions, including the Energy Select Sector SPDR Fund (NYSEARCA:XLE) and Murphy Oil (NYSE:MUR).
Of course, it is possible that there was no agreement at all, in which case oil prices will give up their recent gains. Yet even if an agreement exists, there is no guarantee that OPEC members will actually follow through. OPEC nations have a long history of cheating on their quotas. Only time will tell how much cheating the biggest OPEC producer, Saudi Arabia, will tolerate this time around.
Disclosure: I am/we are long XLE, MUR.
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.
Additional disclosure: XLE and MUR are included in my clients' portfolios as well as my own.