The OPEC Deal Isn't About Shale Anymore; It's About Libya

| About: The United (USO)

Summary

Prospects remain muddled for an OPEC deal.

Libya's restored production and OPEC's target cut are about the same size.

This means that the deal can only hold production steady even if it goes through, since Libya will replace withheld barrels from other members.

Meanwhile, a failed deal could see oversupply swell up again.

It also might threaten OPEC's very existence, as the possibility of withdrawal by some members is now being whispered.

Oil (NYSEARCA:USO) continues its wild ride as rumors fly about the OPEC deal. It's on, off, and on again, with new rumors put to paper almost before traders have finished reading the old ones. But while OPEC has been talking, the ground has shifted beneath it. The deal is now both more important and less significant than before. And yet everything is still riding on it.

Things Were Bad Enough

For months, Saudi Arabia and to a lesser extent Russia have pushed oil prices up by nothing but the power of their tongues. An oil deal was possible, being considered, in the works, tentatively scheduled, anything but actually happening. The oil market didn't seem to care; prices rose from $26 to $50 on nothing more than the power of their words. Even when nothing happened, the Saudis managed to preserve a certain sensation in the market that it was no problem, that things were still more or less on track to eliminate the supply overhang.

Now, however, Saudi talk has finally lost its veneer of nonchalance. As Iran and Iraq both take turns threatening to scuttle a deal, oil has resumed its fall, down to $45 at the time of this writing. And Saudi's latest excuses have truly taken on the air of rationalizing to the point of delusion. Consumption is due to surge, so it's fine if it doesn't cut since the world will just gobble up all that oil anyway; non-OPEC supply will fall far enough that OPEC can have its cake and eat it too, high prices and high output; the Russians will come around to the idea of cutting, not just freezing, eventually, so give them a little more time.

None of this really passes the smell test. Oil prices have been falling for almost three years now, and while consumption has risen, it hasn't been enough to wipe up the entire surplus. Non-OPEC production, which principally means US shale given its short ramp-up and ramp-down time, never fell enough to do the job either. And now it's probably done falling all together. Russia couldn't help manipulate the oil market if it wanted to, since it cannot turn production on and off as easily as Saudi Arabia can. And it doesn't really want to, anyway.

To all of this, however, must now be added another problem for oil bulls.

The Return Of OPEC's Missing Member

The latest reports have OPEC attempting to attain a cut of around 1 mbpd. If you have been following closely, you will note that only puts the target at around 32.8 mbpd, since production last month was 33.8 mbpd. This after saying for weeks that its goal was to hit 32.5 mbpd.

The reason for the disparity is Libya, which has recently announced that it has successfully doubled its oil production to 600,000 bpd, adding 300,000 bpd to the market in a matter of weeks. Libya's next goal is to double production again over the course of 2017.

Much can still go wrong with that plan, of course. Libya remains a war zone in all but name, riven by divisions that see no fewer than three different governments claiming to be the sovereign rulers of Libya, and therefore, of Libya's oil. Its current 600,000 bpd target that it just hit was originally supposed to have been completed in September. Similar delays may well plague the next steps of the nation's recovery.

Unfettered Prospects

But the exact date of the target matters less than the fact that Libya appears to finally be on track to coming back online. Libya lost roughly 1.3 mbpd of production after the civil war in 2011-2012. Without that loss of supply, oil prices would probably have begun their collapse a year or more earlier than they did. If that production, or even just the lion's share of it, is poised to come back online, it has the potential to swallow OPEC's proposed cut whole. In fact, the size of OPEC's target cut (1 mbpd) is exactly identical to the size of Libya's still-offline production. Even if Saudi Arabia, which originally offered exemptions to Iran, Libya, and Nigeria, really does manage to make Iran and Iraq blink and accept cuts, Libya's exemption alone has the potential to restore all of the lost output. That's before Nigeria enters into the picture.

Not that Saudi Arabia has much choice in the matter. Libya was never even considered as a candidate for a production freeze. Requiring it to would have rendered the whole deal nonsensical and non-credible in the eyes of the market, probably killing whatever temporary rally talk of the deal has produced stillborn. Nor is this fact of life likely to change soon. Libya, in fact, has already gone on record saying that not only will it not participate in this round of cuts, it won't be participating in the next round, or the one after that, either.

OPEC Is All-In On This Bet

So while the deal's prospects keep getting dimmer, the stakes keep getting higher. At this point, the purpose of the deal isn't really to shrink oversupply at all. It is to prevent Libya's return to the oil markets from making the oil surplus even worse. Failure now doesn't mean a return to the 700,000 bpd overhang, bad as that would be. It means a return to the days when the extra daily barrels numbered in the millions.

Nor is it just the price rally that is on the line now. The expectation already is that if the deal does in fact fall apart, oil will promptly plunge back below $40. Some are saying a return to $30 is not completely out of the question. Now, there are the faintest beginnings of whispers that if the deal falls apart - by no means certain, but now regarded as a very real possibility - some nations may seriously contemplate a complete withdrawal from the OPEC cartel, so completely will its veneer of supremacy over oil markets has been stripped away.

For this reason, I still believe we will see some sort of agreement tomorrow, even if Saudi Arabia has to pick up more of the slack. That could well yield a short-term bounce back into the $50s for oil. What's more, as I explained before, even the symbolic act of getting Iraq to agree to caps on its production again would be very significant. Even if Iraq's withheld barrels are promptly replaced by barrels from Libya and other countries, it would reassure oil longs that OPEC's second largest member is committed to maintaining the OPEC system going forward. Much could increasingly be said about Iran's cooperation, as it refuses all production caps.

But I expect that bounce to be short-lived, as Libya replaces whatever the rest of the cartel agreed to cut. Meanwhile Saudi Arabia, which is now essentially forced to shoulder cuts by itself since it has promised a deal so vocally, will probably decline to raise hopes for another deal, since much the same drama would probably play out.

Conclusion

After months of waiting, we will finally have an answer tomorrow whether this deal is happening or not. I expect that it will, and that oil will see a short-term recovery. But Libya's resurgence, along with Iran's, and Iraq's, and Nigeria's and shale's, will probably see it fall back in short order thereafter. I recommend avoiding oil over the next few days, and if it does go back into the $50s, I would short it.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in USO over 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.