Positive And Negative Effects Of An OPEC Production Cut

| About: The United (USO)

Summary

Over the short term, an OPEC production cut will be positive for the price of oil.

This assumes any agreement will be adhered to - far from a given.

Further out, competitors will boost production.

The price of oil will come under long-term pressure once U.S. shale producers aggressively increase production.

Pace of demand growth will be determined by depth of upcoming recession.

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Source: Stock Photo

Much has been made of the recent announcement by OPEC that it has agreed in principle to cut production, with the details now being worked out and presumably will be revealed at the next meeting at the end of November.

The mainstream media and a number of alternative media sites have reported this as if there is a deal in place, even though there are a lot of issues surrounding the proposed action - a number of which could easily stop the process in its tracks.

That said, there does appear to be at this time a more optimistic possibility of production cut being implemented than in the recent past, but it needs to be understood this is by no means a guaranteed outcome.

Oddly enough, while asserting an output cut is on the way, OPEC continues to raise its supply to record levels, generating concerns among investors concerning the validity of the alleged deal, and whether or not there's the will to put it in place.

The other concern is not only whether or not OPEC members will adhere to any deal, but if Russia, which is a key player in whether or not the deal will go forward, will line up its production levels with quotas it has agreed to. It has also had a history of making production freeze or cut deals and failing to adhere to the agreement.

If a deal is made, most of that is already priced in, but will be subject to scrutiny in the months ahead, as the market skeptically watches to see if this time around it'll be followed. That means most of what lies ahead is a risk to the downside, even though there will be one more upward push in the price of oil if a production cut agreement is reached.

Short-term benefit of proposed production cut already obvious

I don't personally place any value on OPEC as a swing producer any longer. But in this period of transition to American shale oil producers becoming the dominant force in the oil market, there are still a lot of old school investors and pundits who look at OPEC as still having the ability to influence the oil market as it has in the past.

The upward move in the price of oil confirms, at least in the short term, OPEC is able to temporarily move the price of oil up, but that will without a doubt be frustrated over time - assuming the production cut is made and remains in place - by U.S. shale producers ramping up production and flooding the market with oil. Also important to note is this has been done without an agreement in place, but only by verbal intervention. Once the details are revealed, we'll see at that time how much the cartel will really influence the price of oil in the near future.

What's unique at this time is the length of time it has to do so. OPEC can temporarily have an impact on oil prices until shale production dominates the market. OPEC is done as the swing producer of the oil world, but it still can raise or lower production to impact the oil market, albeit the bulk of its influence will remain on the downside of the price of oil, which it has proven it can influence by keeping the spigots open and oil flowing.

Shale producers now own the mid and upper levels of the price of oil, and only this transitory period allows OPEC to push the price of oil up. What I mean by that is the higher-cost shale producers have cut back on rigs and wells being completed, and it'll take a few months to ramp them up if they decide there is a profit to be made under these market conditions.

Lower-cost shale producers are already quickly adding rigs and completing wells, which once they are all in place, will reverse the direction of U.S. production levels. It's the time it takes to do so that will determine how long the price of oil will find support as the result of any OPEC production cut.

The upcoming recession is still not being priced in

Over the next several years there will be a recession. So far the market isn't pricing this into any sector, including the oil sector.

Most important is how this will have an impact on demand; which, as we've watched economic slowdowns in China and other markets, definitely drives oil demand down. Even a market like India, which is being looked to as the future of oil consumption growth, will be significantly impacted by the recession.

With oil supply remaining very high, along with inventory levels, it's a surety when the pace of demand falls below expectations, the price of oil will plummet as supply overwhelms demand once again.

I think this is one of the reasons some of the major oil producers are reluctant to launch major projects at the pace they have in the past. It's not only the disruptive emergence of the U.S. shale industry that's a concern, but the impact all of the oil flooding the market will have with the next recession, which is now overdue.

Tale of two banks and their take for OPEC production cut

Recent comments from Goldman Sachs (NYSE:GS) and Citigroup (NYSE:C) are a good look at really the only two legitimate views there are for how the OPEC production cuts will play out.

On the side of Goldman, which is the position I hold, it states there is a slightly better chance of there being a production cut than there has been, but if the cuts are made, it will only have a short-term benefit to the price of oil.

In the end, it sees it undermining the cartel once shale production is brought to higher levels.

Citigroup, on the other hand, believes the chance for a deal is "well over 50%." It also interestingly sees the price of oil soaring over 30 percent higher within a year if the asserted production target of about 33 million barrels a day is put in play.

It believes that would result in a shortage of supply, which would be the catalyst for the projected upward move in the price of oil.

How one invests for the long term will be determined by which one of these scenarios is believed. In the short term it really doesn't matter, as most of the money that was to be made has already been made from the jump in oil prices.

Another benefit is this provides a higher bottom for oil until the OPEC meeting brings more visibility to the proposed cuts.

Conclusion

For years there is nothing that will keep American shale producers from being the swing producers in the oil market. OPEC will continue to play a key but secondary role in that regard. Over the long term all it can do is boost production and drive down the price of oil. It can't sustainably support and boost oil prices over the long term. That'll be proven fairly quickly if a deal is made.

What is unique this one time concerning the production cut as it relates to the U.S. shale industry is the low price of oil and high costs associated with some shale producers have temporarily held back the full force the shale producers can bring to the market. That will allow for this one-off seasonal impact from OPEC; the last time in my view it'll be able to do so.

How long this period of influence is will be determined by how quickly the lower cost shale producers can bring supply to the market. The unknown now is how productive the added rigs and wells will be, as they'll outproduce the wells in service over the last couple of years.

That's why the number of rigs isn't as important as it used to be, neither the number of wells. New technology and methodology are allowing shale producers to be much more efficient and productive; which once they have completed their new portfolios of premium wells will give a clearer picture, as to how much more oil these rigs and wells can produce. We won't know until they are operational, meaning not only a few being added here and there, but the entirety of the portfolio being in play.

Add to that the recession that is coming and we have a unique set of circumstances that haven't been faced by the oil industry in the past.

My belief is this is the last hoorah of OPEC and even though it may possibly have a temporary impact on the mid- and upper price of oil, there is no way it'll be able to hold when U.S. shale producers start to come at them.

As already confirmed, verbal intervention has done the work of boosting and supporting the price of oil. There isn't a lot more upside with the exception of an announcement in November that there is a deal in place. That will give a nice push to the price of oil, but it won't last once the market starts to price in additional supply from shale producers.

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.