Why OPEC's 'Freeze' Announcement Was Worse Than None At All

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Robert Boslego

Summary

The possibility of an OPEC production cut lifted prices.

The announcement of a bogus agreement sent prices lower.

OPEC is better off hinting at possible cuts, than making such statements.

OPEC has been largely unsuccessful in enforcing cartel agreements.

Its only real triumph was the Arab oil embargo and that was short-lived.

Qatar's Minister of Energy and Industry Mohammed Saleh al-Sada (center), Saudi Arabia's minister of Oil and Mineral Resources Ali al-Naimi (left), and Russia's Energy Minister Alexander Novak attend a press conference Tuesday in the Qatari capital Doha. Source: (OLYA MORVAN/AFP/Getty Images)

The rumor of a meeting by OPEC oil producers on Friday to cut oil production resulted in a surge in oil prices of 12%. Such a development would be the primary catalyst for oil prices to rise.

The announcement by the four producers - Saudi Arabia, Russia, Venezuela, and Qatar - to freeze production at January levels is a joke. It would freeze production at January 2016 levels, which happened to be near the highest level Russia has produced, about 10.8 million barrels per day (mmbd), and a very high level for Saudi Arabia, 10.2 mmbd, according to OPEC's most recent estimate.

Russian production is expected to decline in 2016. It is therefore not agreeing to give anything up. Saudi Arabia's production is believed to be at or about its capacity since it had been trying to kill off production from shale oil. If it could produce more, there is little doubt it would.

Furthermore, the "deal" contained the condition that other producers would have to join in the freeze. Iran has taken the position that it will boost production by 500,000 to 1 million barrels per day this year following the lifting of the sanctions. Iraq and Libya may be able to increase production over time, depending on the status of its internal conflicts.

Uncertainty v. Certainty

The uncertainty of a possible deal to cut output lifted oil prices on Friday by 12%. The certainty of a deal that has no credibility or importance caused prices to drop by 4% today (February 16th). What I think this proves is that there is greater value in hinting at the possibility of an agreement. If it lifts prices by $5-$10 per barrel, that's $5-$10 billion added revenue for OPEC producers in one month.

The tendering of a deal in public is of no value to OPEC. It only focuses the market on the difficulties of defining production limits for each producer and enforcing them. The vexing problem for any cartel is that all members are better off (for some period of time) if they restrict production collectively, but each member has a financial incentive to cheat, as long as the others are "faithful."

The market fails to recognize that OPEC only successfully acted as a cartel once in its history, and then it was only a subset of members, then known as the Organization of Arab Petroleum Exporting Countries (OAPEC), plus Egypt and Syria. It was the 1973-74 Arab oil embargo.

The embargo was a response to American involvement in the 1973 Yom Kippur War. For political purposes, in response to this, OAPEC announced an oil embargo against Canada, Japan, the Netherlands, the United Kingdom and the U.S. in October 1973.

OPEC production fell from 31.5 million barrels per day (mmbd) in September 1973 to 27.5 mmbd in December 1973, a cut off 3.0 mmbd. The lion's share of the cut, 2.3 mmbd, was due to Saudi Arabia's actions.

When prices spike by a factor of four, greed took over and the producers began to ramp up supplies again to cash-in. Saudi Arabia increased its production by 1.3 mmbd from November 1973 to January 1974.

The embargo ended in March 1974. It was not effective in reducing supplies to the intended countries. The "Seven Sisters," the major oil companies as they were known then, reallocated global supplies among countries such that all consumers worldwide suffered to the same degree, about 15%.

But the embargo taught OPEC the profit-making potential of reducing supplies of highly inelastic goods (NYSEARCA:OIL). It also showed the near-impossibility of enforcing cartel behavior, even among countries with similar political objectives.

OPEC's only future real success in limiting output to control prices was due to Saudi Arabia. Following the Iranian Revolution in 1978-79 and the Iran-Iraq war in 1979-80, prices spiked due to the cut in output by those countries. Saudi Arabia tried to keep prices higher until late 1985 by cutting back production. However, it capitulated when its production fell below 3 mmbd.

Conclusions

If OPEC wants to add $5-$10 billion per month in revenues, it should make the market think it might cut output in a continuing series of hints. Traders would get gun-shy shorting the market at low levels. Publicly disclosing the type of statement it made today does it no good.

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.