Note: This was first published to HFI Research premium subscribers on Nov 13. If you are interested in getting our weekly outlook, please sign up here.
This week's weekly oil markets outlook format will be different than normal. With the OPEC producer meeting at the end of November, the overwhelming short-term impact to oil prices and energy equities will be riding on the outcome of this deal. More important, this deal will shift the sentiment of the consensus from believing an oil market in surplus to deficit. In our opinion, the sentiment shift is more important than the actual implications of a deal.
As of the latest survey estimate for OPEC production in October, analysts peg OPEC production at 33.64 million b/d while IEA pegs production at 33.83 million b/d.
The Algiers meeting agreement was that OPEC would keep production between 32.5 - 33 million b/d.
The Algiers meeting production level is 640k - 1.33 million b/d lower (depending on which end points) than current production.
Here's a dose of reality, oil production declines.
New production is flush, so initial production will always produce more oil (NYSEARCA:USO) than legacy well production.
Looking at the recent ramp up in production, we know this is going to fall over the next 12 months. Now why are OPEC producers ramping up production right before the OPEC producer meeting? Because they can use the higher production as baseline for negotiation knowing full well that production will soon decline in the coming months, and growth in production will likely stay flat for 12 months.
Remember this before reading any "boasting statements" from OPEC producers, $ results in production growth. No $, no production growth. We can't highlight this point enough, because people in the media seems to think OPEC producers can pump oil out of their... instead.
Game of Chicken
Facing the harsh reality that current oil prices just aren't high enough to meet fiscal and monetary budgets, OPEC producers have turned to producing more oil to fill gaps. Like the stranded adventurer at sea, drinking salt water does not quench the thirst, let alone drinking more of it.
OPEC producers seem to have the illusion that instead of cutting budgetary needs and reducing costs, drilling more oil at half the original revenue will somehow fill the fiscal gap. We say, "Dream on friends, for the gaps will only grow ever wider."
Now instead of working together and figuring out how to strategically reduce overall oil production, each OPEC producer is trying to gain an advantage over one another by leveraging drilling tactics that temporarily boost oil production at the detriment of long-term production. Like greedy kids that want to eat as much candy as possible, OPEC producers know the harsh reality of lower oil production is coming. And like gravity, the difference between what it costs to grow production will never change, and reality will soon smack each one of them like the inevitable day of reckoning that's to come.
Saudi knows this and it's exceedingly frustrating to have to negotiate with these terrible poker players with the 2, 7 off suit. What's more increasingly an issue however is that Saudi's hand is not so good either, and it needs higher oil prices to meet its 2030 vision. Saudi's economy is tethering, and with increasing pressure to devalue its currency, its 2030 vision is slipping away in front of its eyes ever so slowly.
It's never just about oil, because if it was, OPEC should only produce 17 million b/d and let the world starve. Because in reality, making prices higher than its economic equilibrium is the goal if one has control to 33% of the global supply.
The situation happening in Yemen and Syria is absolutely terrible. And the geopolitical tensions that arise from this is because Saudi Arabia has always had the backing of US's military presence. Call it conspiracy theory or not, but the Saudi administration has always donated to the Clintons, Bush, Obama, and practically every single political candidate. So politicians in the past could never ignore the wishes of one of its biggest donors.
Now with Trump as President, things are about to flip 180 for Saudi Arabia. And the geopolitical ramifications are quite positive for the Middle East region. Conflicts in Syria was worsened by the US as Saudi backed rebels (supplied by US weapons) entered in Syria in an attempt to overthrow Assad. Saudi seeks Syria as a channel to export natural gas to Europe. Assad just so happens to be protected from Russia, as Russia is currently the largest natural gas exporter to Europe. The European gas market is extremely lucrative because Europe produces very little natural gas and prices have always been high.
With Assad in trouble, Russia couldn't sit back and let the Saudis take over. So a war broke out and has now ruined Aleppo. With Trump now as president, the US won't be able to sanction any support from now till January, and this gives Putin the chance to retake Syria. No negotiations needed, and that's how Putin sees it anyways.
Once Trump becomes President, and because the US should owe no favors to Saudi Arabia, US will effectively stop supporting Saudi backed rebels, and this will effectively give Syria back to Assad. Once this conflict ends, Saudi will recognize that it no longer has the ability to use US forces as its own, and the Middle East conflicts will die down.
The resulting implications from a more peaceful Middle East is that Saudi will shift more of its focus to its economy and how it can build its own military up. With the US as bystanders now, Saudi will need much higher oil prices if it was to successfully defend itself in Middle East.
From a geopolitical standpoint, peaceful periods in the Middle East have always translated into higher oil prices. As the countries aren't trying to kill each other, the OPEC negotiations are much easier, and with economic interests aligned, they would all share in the fruits of higher oil prices.
Geopolitical tensions only arise when countries have nothing important to do. In Maslow's hierarchy of needs, the basic needs must be met first before anything else.
Why else do you think countries in Africa never bud into anyone else's business? Or countries like Oman never bother with geopolitical tensions with the Saudis?
Saudis have been swashed in money for far too long and the reality is slowly setting in. As its economy's growth slows tremendously, and the long-term vision of the country at crossfire with technology (electric cars, renewable energy), its only bread winner (NYSEARCA:OIL) will need to rise once again to fill all the gaps that the recent downturn created.
Saudis can no longer conduct Middle East geopolitical events like its own, and with the new President highly unlikely to support the anti-humanitarian actions the Saudis have recently taken, the tone will swiftly change to one that's more focused on its own economy rather than social issues.
From our analysis of Saudi's incentives, geopolitical motivations, and its economy, we think the Saudis and its gulf allies will cut oil production to the 32.5 - 33 million b/d target. Iran, Iraq and other OPEC producers will likely agree to the November production level.
In all, we think the total supply cut might be 800k - 1.3 million b/d for the deal. Looking at Saudi's recent oil production of 10.6 million b/d, we know that the normal seasonal decline is for Saudi's oil production to drop from 10.8 to 10.2 million b/d. This means that Saudi will see its production decline by another 400k b/d. We think Saudi will cut production by an additional 200k b/d to 10 million b/d, while its Gulf allies contribute another 100k b/d of cut bringing total supply cut to 900k b/d.
If OPEC announces that it will keep production at 33 million b/d, we think the market will react very favorably to the announcement, and oil prices will move past $50 and trend towards $60 by year end.
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.