The conventional explanations for OPEC not cutting the production
The OPEC leaving production quotas unchanged has naturally been the top news last week and most investors have spent at least some time over the weekend to reflect on the implications of the move on their portfolios. There have been several theories and explanations as to why the OPEC didn't cut. The obvious reasons stretch from the lack of agreement between OPEC members on whether to cut, by how, and most importantly, how much production each country sacrifices. Other explanations include the strategy of the dominant OPEC member, Saudi Arabia, to let the prices fall in order to squeeze out high-cost oil producers, such as Canadian oil sands and U.S. shale oil. The explanations or speculations also include some supposed secret deal between the U.S. and Saudi Arabia to damage Russia, Iran, ISIS and other "rogue" regimes or interest groups around the world. There are certainly many more theories for why OPEC didn't cut.
Saudis are most probably thinking long term, so any explanation needs to include a combination of short term and long-term strategic goals. And the question also lingers whether OPEC still has enough power over oil prices.
Is this the real reason why Saudis didn't cut?
There have been plenty of explanations why the OPEC didn't cut production quotas. But there is one very long-term strategic reason why the price fall may be welcome by OPEC. This explanation has not been discussed too much, at least I haven't seen it mentioned. Yet over the very long, very strategic time horizon, this would be the most probable explanation for letting the price of oil to fall now.
Who is the biggest competitor for the Saudis, or OPEC countries? Is it Canada? Is it the U.S.? Russia? Offshore Africa? The answer is no. Let me give you a hint. What is the biggest threat to not just Saudi Arabia, or OPEC, but to all oil producers? The answer is simple:
The biggest threat to all oil producers of the world is the high oil price. (No, that's not a typo).
Alternative energy sources are the true competitor of all participants in the oil and gas industry.
High price of oil spurs faster development and implementation of alternative energy technologies. It is just a matter of time before solar, wind and other alternative sources of energy will become competitive or cheaper than oil and gas in many applications. In some places they already are. Sometimes even without any subsidies and including the benefits that oil and gas industry receives in the form of free negative externalities, such as the damage to the water and environment in general. To be fair, the negative environmental impact of the solar panel production and disposition is rarely mentioned.
Moreover, the cost of generating alternative energy has been falling and there is no reason why the cost should stop falling as the technological process keeps leaping ahead. It will probably take centuries before the world runs out of good sunny or windy spots (Sahara, Saudi desert - interestingly, Southern U.S. for solar and plenty of shores for wind are just some examples), so the costs to extract additional alternative energy megawatts will not rise. Plus, the sun rises every day, so the source of this energy is almost infinite and doesn't deplete or deteriorate. It is like a fixed cost which will never rise over time.
On the other hand, the reserves of oil and gas are finite and the cost of extracting an additional barrel of oil has been rising - and will most probably keep rising - due to cheap sources of oil being always extracted first as well as due to generally rising overall costs associated with oil production.
Alternative energy space is rapidly developing
The recent technical development in the area of electricity storage (batteries, etc.) and alternative energy is surprisingly fast. Panasonic, Tesla and many others are investing in cheaper and more efficient large-scale batteries for economically viable electricity storage. The sales of electric cars, while still tiny, grow at rapid annual rates globally. Hydrogen fuel cell powered cars are emerging (Honda, Hyundai and Toyota already sold/leased some hydrogen models to the public, Audi has a fully functional prototype, many other brands are at similar stages but the technology is evolving rapidly). Ironically, hydrogen is usually produced from natural gas or methane. However, the efficiency is roughly 80%, which is extremely high, much higher than conventional combustion engines. Natural gas also has a much lower value for the oil and gas producers than the oil (lots of it is still just burnt on the spot). So the overall revenue for the oil and gas industry will be significantly lower from a hydrogen-powered car than from a conventional gasoline car. The same holds true for electric cars of course. The hydrogen fueling stations infrastructure is in its infancy, and only a true fan would buy/rent a hydrogen car now, but judging from the hydrogen car mileage and activities of car manufacturers, fuel cell infrastructure may be just 2-3 years behind the electric vehicle infrastructure. If some favorable legislation chips in, the gap could actually close very soon.
But cars are just one of many examples of how alternative energy sources threaten to replace significant volumes of oil in the future. On the other end of the spectrum are speculative developments, such as the fusion power which has been a fata-morgana for many decades. Even a working solution now would probably take five to ten years to make it commercially available. However, Lockheed Martin now claims to have made a breakthrough in fusion technology, offering no details though. So their claim may easily be just part of a creative PR campaign. (I am not suggesting they are lying, but I have to discount the information because there is no way to prove it)
Oil is here to stay for decades
Of course lots of oil will still need to be consumed, for many decades to come. But the market will be shrinking or stagnant in dollar terms. Actual physical volumes may moderately rise. The improvements in power consumption efficiencies are not exactly going to help the price and volume. On the other hand, growing global population and rising buying power of a global consumer is a major positive factor. All in all, I believe the current oil price weakness will continue only in the short run. The prices of WTI crude should stabilize in the medium term of several months or quarters at the level of $60-$80 per barrel.
The only way many oil and gas exporting countries can survive in the long run
Oil and gas revenues are often a dominant source of income for the producing countries. To say many are very dependent on oil and gas revenues is a gross understatement. Preserving at least some oil and gas revenue is a matter of life and death for these countries. Therefore, the only way to survive the next few decades for most oil and gas producing countries is to cut the price of oil drastically NOW. That is their only chance to at least slow down the development and implementation of alternative energy sources into widespread usage, before it is too late from their point of view. If they fail, the price of oil will get stuck at much lower levels almost permanently.
OPEC will lose relevance if it doesn't manage to reform and include virtually all major oil producers in quota negotiations
Higher-cost producers are planning to increase their oil/oil products exports to global markets. For example, Canada prepares to sign a free trade agreement with South Korea "in the coming months" which will cut crude oil and LNG duties by 3% and by 8% on refined products virtually immediately upon signing the deal, and this deal would serve as a "gateway to the wider Asia-Pacific region"). Similarly, the U.S. has been warming up to the idea of looser oil export policies and discussing a free trade deal with the EU. The fact that Saudi Arabia recently cut price for its U.S. customers while raising them for Asia would give some more support the theory that the North American market and its producers are the prime target of its strategy. And this is probably the medium-term goal of the Saudis, according to my opinion.
The fact that oil prices topped in the middle of June, almost exactly on the date when the message about the planned free trade agreement with South Korea was officially released (June 16, 2014), is certainly an interesting coincidence. Or is it? Additionally, it is likely that the Saudis see the waning pricing power of OPEC due to flexible production from the U.S. shale oil fields which can be quickly boosted or cut in order to influence the total world production. This ability takes away the power over oil from the Saudis which have possessed this power to adjust production until recently. Therefore, the Saudis probably try to reign in all OPEC members and force them to respect the set quotas and share any potential cuts among all members, without the Saudis bearing most of the quota cut. But the falling oil price has an interesting historical parallel and implications.
Lower price of oil serves as an inverse oil price shock (the opposite of the 70's)
Besides the conventional explanations for the current oil price slump, there is a surprising inverse historical parallel - the first and second oil price shock in the 70's (1973 and 1979). Back then, prices of oil spiked rapidly and remained high and the time was generally characterized by booming population growth, young population, rapid inflation, high interest rates which subsequently caused a supply-side shock and a recession. But this period also spurred unprecedented innovation around the world with advances in robotics, miniaturization, semiconductors, and other fields which radically improved efficiencies which decreased energy and material intensity of production, especially in Japan.
The current situation is almost exactly the opposite. The price of oil is not rising but falling rapidly. Inflation is extremely low (parts of the world already experience deflation), aggregate demand is sluggish amid falling real income, almost non-existent population growth and aging population (in the U.S. and other developed countries). All this discourages investments in energy innovation and energy efficiency (low interest rates help a lot, though).
Existing alternative energy solutions are becoming more and more uneconomical compared to falling price of oil and gas, and the opportunity cost of using subsidized "green" energy is rising relative to cheaper oil. Existing subsidies suddenly may not be high enough to cover the costs to install further alternative energy capacities. Investments into further alternative energy R&D will be hard to obtain due to low potential ROI of the innovations if the future price of oil is expected to remain low. This will help conserve the status quo or at least slow down alternative energy advances. For the current oil producers - from all around the world, not only for Saudi Arabia or OPEC - lower prices are great news in the long run, even though they are painful now.
My oil price outlook
In the short run (several months and quarters), I am very bearish on oil prices because the oil producers have motivation to keep the price low until the highly leveraged, high-cost oil producers go out of business or are bought for pennies by their stronger competitors. Also, oil producing countries would need to maintain at least several quarters of weak oil to discourage long-term investments into alternative energy innovation, possibly until the current round of alternative energy R&D companies and some solar energy companies go out of business or consolidate.
However, over the medium to long term (years and decades), I am neutral to moderately bullish on oil prices as I believe the markets and industry will find a decent equilibrium around $60-80 per barrel. However, I don't expect long-lasting spikes above $90-100 per barrel (barring the global security situation getting out of hand) because the flexible U.S. shale producers currently hold a permanent "call option" on the oil market. Every time the price spikes, they will quickly add more production, balancing the market. It is quite similar to the Bernanke put option, just working the opposite way and in oil.
I opened a long position in United States Oil ETF (NYSEARCA:USO) (selling covered calls to help mitigate contango issues) and Seadrill (NYSE:SDRL) late last week. I am also considering establishing a long position in British Petroleum (NYSE:BP). Furthermore, for long-term investors with high risk tolerance, I recommend smaller positions in more speculative and risky oil and gas services small-cap stocks which I analyzed in the past few weeks. These include Tidewater (NYSE:TDW), TGC Industries (NASDAQ:TGE), Dawson Geophysical (NASDAQ:DWSN), GulfMark Offshore (NYSE:GLF), Ion Geophysical (NYSE:IO) and CGG Industries (NYSE:CGG). I don't hold any positions in any of these due to my preference for a highly concentrated portfolio but may decide to open long positions depending on future situation.
Disclosure: The author is long USO, SDRL.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.