Regardless Of OPEC, Oil Will Eventually Rally

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Summary

OPEC is meeting on November 30th and is attempting an agreement for a production cut of 4.0% to 4.5%.

As usual, some countries are objecting and it is possible an agreement won't be reached.

OPEC production will not be going much higher regardless because OPEC is close to maximum output.

Oil has been in a trading range since June and will eventually break out to the upside.

In the oil market, all eyes are on the behind the scenes jockeying for the OPEC meeting on November 30th. In pre-meeting activities, the 14-member cartel is trying to work out an agreement for a 4.0% to 4.5% cut for all members except Libya and Nigeria. This would cut production down to 32.5 to 33 million barrels per day (bpd) from a recent record output of 33.8 million bpd. Negotiations were seemingly postponed on Tuesday, November 22nd when Iran, Iraq and Indonesia expressed reservations. Whether or not an agreement is reached will not likely to be known until the meeting itself. In the long-term, it won't matter.

Market commentators have engaged in major hand wringing over whether or not OPEC will reach an agreement that is far out of proportion to its importance. Every article written on the subjects points out that OPEC output is at an all-time high. Few, if any, mention that demand is also at an all-time high and growing rapidly. Nor, is it pointed out that, with few exceptions, will it not be easy to increase supply because most OPEC countries and Russia (one of the top three global producers along with Saudi Arabia and the United States) are already operating around maximum capacity.

There is still some slack in production in Iran because it was under sanctions for years and was under producing. Libya can still increase production somewhat, as it recovers from its civil war and Nigeria's oil production could be greater, but is restrained by rebel activity in its oil producing regions. It is projected that Nigerian output will drop in 2017 because of the internal conflict, so there is no need to cap its production. Other than that, most countries, with the exception of the United States (not part of OPEC, which is also the case with Russia) are operating close to or at full capacity.

The often ignored reality that production has little room to increase among OPEC countries can be seen in the chart below. The blue bars are surplus capacity. Note that surplus capacity in 2016 is the same or a little less than in 2008. This is significant because the price of WTI crude went to almost $150 per barrel in 2008. While it would be thought that production would have skyrocketed to take advantage of the incredibly high prices, it didn't. Long-term projects were underway, especially in Saudi Arabia to bring more oil online, but most of these came to fruition in 2009 and 2010, after the price of oil had already fallen considerably. By 2016, once again OPEC production was bumping up against a ceiling just as it did in 2008. Production capacity doesn't increase gradually and continuously, but by large chunks every now and then. This is because significant infrastructure needs to be put into place and this can take years to implement for any given field.

At current low oil prices, however, it isn't worthwhile to invest in expensive infrastructure projects. A study by Wood Mackenzie estimates that CapEx (capital expenditure) in the oil and gas markets will be down $91 billion in 2016. Considerable CapEx expenditure is needed just to maintain production levels. This means keeping oil production at current high levels will be difficult. Nevertheless, the EIA estimates that OPEC oil production will increase by 0.68 million bpd in 2017. It also estimates that global consumption will be higher by 1.52 million bpd next year. Who will produce the extra oil needed?

While most articles written about oil mention a glut in supply, they fail to explain how the price of oil managed to double between February and June of this year if this is the case. Price wouldn't have risen if the market was really as out of balance as is often claimed. After June, oil prices entered a trading range with approximately $42 per barrel as a low and $53 per barrel as a high (this was first discussed here). The breakout from this range will take out on the upside. What is preventing this is seasonal weakness. Oil prices usually hit their yearly lows in December and then again in February. Price then rallies into the summer. Once oil breaks above $53 per barrel, there will be major resistance around $60. This is the price where fracking in the United States starts to become profitable enough to expand production. This is not a fixed number, however, higher interest rates will raise this pivotal price (rates jumped precipitously after the U.S. presidential election).

WTI Oil Price 2016 Year-to-Date


Red lines indicate high and low of trading range of oil prices

For the moment, investors should pay attention to the trading range. It will take longer for a breakout to the upside if OPEC doesn't agree to cut production on November 30th, but it will still happen. Production is likely to be challenged in 2017 regardless because of the lack of CAPEX spending. The market will realize this, although it might take some time. Buy toward the bottom of the range and sell toward the top until prices rise above the $53 per barrel level, then go long until $60 per barrel is reached. There are a number of ETFs that can be used to take a position in oil. These include: USO, USL, OIL, DBO, UCO and UWTI. Leveraged ETFs UCO and UWTI are trading vehicles and should not be held for more than a few weeks at a time.

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.