OPEC Cuts To Drain The Oil Swamp

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Summary

OPEC assigns quotas to most members. .

Libya and Nigeria permitted to restore output, if they can.

Their success--or lack thereof--is the main uncertainty.

If they are successful, prices will be contained because production will likely be 33-34 mmbd.

If not, prices move higher but that helps bring back Amercian shale oil production.

At the end of August, I had written that Saudi Arabia had "thrown in the towel" on OPEC's failed price war for market share. A month later, OPEC met and announced that it had reached an accord in Algiers to reduce production to the 32.5 to 33.0 million barrel per day range. But there was one major problem: there was no "effective mechanism" for implementing the agreement among countries.

On Wednesday, OPEC made a surprise announcement, assigning production quotas for most (but not all) of its members, effective January. I didn't expect this agreement because OPEC rhetoric and press releases have been all talk and no action since February. Also, key producers, such as Iran and Iraq, have said bluntly that they would not cut, and so this agreement is definitely questionable as another PR stunt to talk-up the market without actually cutting.

OPEC has used production quotas in the past, but there is an incentive for each individual member to cheat, if the cartel as a whole abides by them. This is why cartels are unstable and rarely succeed for any significant duration.

Many news analyses cite OPEC's success as a cartel, but those reports are quite untrue. OPEC has rarely acted as a cartel, allocating production to limit output and control prices. The only oil embargo in 1973 fell apart in a few months, as greed of higher prices sparked resumed production.


Source: OPEC.

This agreement is intended to rein-in the oversupply, which has plagued the oil market. This was a total reversal in strategy to the one OPEC, led by Saudi Arabia, had been pursuing. The strategy was originally directed at American shale oil producers, so this reversal signifies a victory in the battle. I wrote it was a $500 billion blunder (in its first year).

MBD

Reference

Adjustment

January

Algeria

1,089

(50)

1,039

-4.6%

Angola

1,751

(78)

1,673

-4.5%

Ecuador

548

(26)

522

-4.7%

Gabon

202

(9)

193

-4.5%

Indonesia

Iran

3,690

90

3,780

2.4%

Iraq

4,561

(210)

4,351

-4.6%

Kuwait

2,838

(131)

2,707

-4.6%

Libya

Nigeria

Qatar

648

(30)

618

-4.6%

Saudi Arabia

10,544

(486)

10,058

-4.6%

UAE

3,013

(139)

2,874

-4.6%

Venezuela

2,067

(95)

1,972

-4.6%

30,951

(1,164)

29,787

-3.8%

Click to enlarge

(Note: There was an error in the OPEC Agreement stating the "Reference" production for Iran, which I corrected in the above table.)

How effective OPEC will be in draining oil inventories remains to be seen. They have allowed Nigeria and Libya room to restore their oil industries, though the success of these producers to do so is highly uncertain. If they are able to add much more production, OPEC output could rise far above the 32.5 million barrel target, still limiting prices.

If they are not successful, and if oil prices surge into the $55 to $65/b range, the American shale oil industry will, in time, restore its production loss of about one million barrels per day, and could keep growing.

And so the agreement is not without its risks, assuming it's followed in the first place. And we won't have data on January's output until the first part of February, so OPEC just bought itself two months' time and another month of overproduction.

Nigeria and Libya

A closer look at the agreement reveals some holes. There were no limits placed on three producers, Indonesia, Libya or Nigeria. Indonesia suspended its membership in OPEC, because it must not have been willing. It has become a net oil importer, and so higher oil prices hurt the country economically. Libya and Nigeria were given a "free pass" to restore their oil industries, which have been disrupted.

And that is why the figures do not add up to the 32.5 ceiling. If Nigeria and Libya restore their production levels to 1.9 and 1.5 million barrels per day, respectively, OPEC will be producing 33.9 million barrels per day.

MBD

Algeria

1,039

Angola

1,673

Ecuador

522

Gabon

193

Indonesia

720

Iran

3,797

Iraq

4,351

Kuwait

2,707

Libya

1,500

Nigeria

1,900

Qatar

618

Saudi Arabia

10,058

UAE

2,874

Venezuela

1,972

33,924

Click to enlarge

Libya's goal is to achieve production of 900,000 b/d by year-end and 1.5 million barrels per day by mid-2017.

If prices rise, Nigeria may be able to resolve the problems of terrorists disrupting pipeline shipments.

American Shale Oil

U.S. crude production peaked in April of 2015 at about 9.7 million barrels per day. It dropped to 8.6 million barrels daily (mmbd) in September 2016, though the dip from August was due to hurricane disruptions in the Gulf.

Click to enlarge

The Energy Information Administration (EIA) has projected that U.S. output will rise to about 8.9 mmbd by end-December 2017. But that figure could be higher with a more substantial increase in oil prices. There are more than 5,000 "drilled but uncompleted" wells (DUCs) that could potentially be completed.

Conclusions

If oil prices move up much, there should be substantial hedging by shale oil firms for years into the future. This hedge selling will tend to limit the price rise. But it could ensure a healthy oil industry for years ahead with rising production here at home.

The Saudis intend to monetize (sell) their reserves, creating a $2 trillion wealth fund that would be diversified away from oil price risks. But it will take many years to accomplish that.

In the meantime, they will have to live with the annoying thought that America's shale oil companies will prosper on the back of their cuts. Continental Resources (NYSE:CLR)'s Harold Hamm gained about $3 billion due to a 23% increase in the stock's price Wednesday.

Click to enlarge

Source: Forbes.

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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.