The OPEC Agreement Is Meaningless

| About: The United (USO)

Summary

Finally there seem to be some OPEC supply freeze/cut agreement, a turnaround from a disastrous strategy.

Even if it sticks, it isn't likely to achieve a great deal though.

An increase in the oil price will simply be filled by increasing supply, mainly from US shale.

It seemed a good idea at the time. Unleash a wave of supply on the oil market to engineer a price fall that pushes unconventional producers with their much higher cost over the wall.

After all, the Saudi's had applied this strategy successfully in the past. With their $9 per barrel production cost and the second highest reserves in the world (estimated at 266 billion barrels), their traditional role as swing producer enabled it to pull this off.

Two years later and the strategy lies in ruins. Some basic facts:

  • OPEC earned $404B in oil revenues in 2015, down 46% from 2014 (at $753B). The EIA forecasts that OPEC's revenues will fall further to $341B in 2016.
  • US shale producers have cut their production cost in half, from somewhere between $50 -$80 a barrel to as low as $23.35 per barrel.
  • We read that the enormous war the Saudi's unleashed upon the oil market has gained it a 1%(!) increase in market share.
  • But with any OPEC deal, it's likely to lose that 1% gain and then some.

And some more direct reasons on why the Saudi's had to change tack:

  • Foreign currency reserves have dropped to $550B from $746B
  • The budget deficit reached a whopping 15.9% last year and despite savage cutbacks, it will still reach 13% this year.
  • M3 (broad money in circulation) contracted 8%, mostly as a consequence of defending the peg with the US dollar.

The ambitious Saudi plan Vision 2030 to diversify the economy and weak the economy of its petrol addiction is in danger, let alone the plans to accumulate a $3 trillion wealth fund in order to become an investment superpower.

In fact, the Saudi policy was a double disaster:

  • Efforts to maintain or gain market share by flooding the market have led to a financial disaster and have only strengthened the US shale competition.
  • As a result, any effort of a reversal in policy will result in rapidly increasing US shale production and OPEC market loss.

So the policy cannot simply be reversed. Permanent damage has been done to OPEC's prospects, a fact not lost on the main architect of the policy (from Bloomberg):

But OPEC's policies now are misguided, according to Ali Al-Naimi, the former Saudi oil minister who masterminded the pump-at-will policy the group adopted two years ago. Trying to drive prices up will only lead to loss of market share, so OPEC should just get out of the way and let capitalism run its course, Al-Naimi said in "Out of the Desert," his new memoir.

And while they try to do just that, with the still vague deal that has just been concluded, even that might not be all that it seems, here is Jim Cramer (from CNBC):

"Going into the meeting, the Saudis upped their production to about 11 million barrels a day, from 10 million, so they are simply going back to where they were last year," Cramer said.

Apart from keeping the OPEC frogs in the basked, in the medium term, they have a more serious problem to deal with:

Victorious shale

By all accounts, US shale has benefited greatly as a result of the Saudi led oil strategy. Then there are great new discoveries (from CNN):

Geologists say a new survey shows an oilfield in west Texas dwarfs others found so far in the United States, according to the US Geological Survey. The Midland Basin of the Wolfcamp Shale area in the Permian Basin is now estimated to have 20 billion barrels of oil and 1.6 billion barrels of natural gas, according to a new assessment by the USGS. That makes it three times larger than the assessment of the oil in the mammoth Bakken formation in North Dakota.

And then there was this surprising development (from Rystad):

A new independent estimate of world oil reserves has been released by Rystad Energy, showing that the US now holds more recoverable oil reserves than both Saudi Arabia and Russia. For US, more than 50% of remaining oil reserves is unconventional shale oil. Texas alone holds more than 60 billion barrels of shale oil according to this new data.

One has to combine this fact with the following (from WorldOil):

Rystad Energy's latest North American Shale Report shows that the average wellhead break-even price has decreased on average by 22% year-over-year from 2013 to 2016. The most commercial wells currently exhibit breakeven prices between $25 and $30/bbl. Among the key shale plays, Permian Midland has experienced the largest drop in breakeven prices, falling by 33% year-over-year on average from 2014 to 2016.

Is there any reason to assume that this decline in breakeven prices will suddenly come to a halt, or even slow down? What this means is that the US combines an ever increasing size of oil (and gas) resources with rapidly falling breakeven prices.

While new oil discoveries slump to a 60 year low and investment in new projects has declined sharply, US shale is now the lowest cost option for future oil production and are likely to attract more investment than deepwater fields, according to Wood Mackenzie (from FT.com).

These big deepwater fields and other costly projects like arctic fields require lead times of at least 7 years, there are reasons to assume that not many of these projects will receive the often massive funding they require.

And they might become a form of endangered species (from WorldOil):

The decommissioning of aging offshore oil and gas platforms, subsea wells and related assets is increasing dramatically, with more than 600 projects expected to be disposed of during the next five years. This rapid trend toward decommissioning is causing spending to rise significantly, according to a new study by IHS Markit. IHS Markit expects spending on decommissioning projects to increase from approximately $2.4 billion in 2015, to $13 billion-per-year by 2040, or an increase of 540%

One would have to be able to foresee the oil price a decade out and there are reasons to assume why this is particularly difficult:

  • The increasing resources and cheapening of US shale
  • Uncertainty over the future of oil demand.

Conclusion

Even if the OPEC agreement holds and every country sticks to it (history tells otherwise), it isn't going to achieve a great deal. Yes, prices will recover somewhat, as the 8% rally on the day of the agreement shows.

But this is going to invoke additional US production, it's only a temporary reprieve unless some major disruption to supply emerges somewhere.

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.