Oil Production Freeze Initiative Quickly Unraveling

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

Summary

Oil production freeze losing steam as a growing number of countries not supportive of it.

Russian Energy Minister expresses uncertainty on whether or not a meeting will be held in April.

Investors need to be wary of investing based upon a freeze agreement which some wrongly believe could lead to cuts.

Even if there is an agreement it would do nothing to alleviate oversupply.

source: Stock Photo

The proposed oil production freeze picture is getting murkier and less compelling, as some countries have no interest in even meeting to talk about an agreement, and there are others like Kuwait that won't agree to a freeze if the rest don't.

Now that Libya has announced it won't attend a meeting in April to talk about a production freeze, it has to be assumed Kuwait isn't going to agree to anything, as Iran won't enter into an agreement of any kind either.

The forces involved in this are those like Venezuela, which are losing a lot of revenue from the low price of oil, and those like Iran and Libya who are looking to increase supply. There is no point where the opposing interests are reconcilable. Thus any oil production freeze agreement will have no teeth in it when competitors continue to do what's in their own best interests.

Also important to understand is under the very best outcome of an agreement, which would entail competitors locking production in at January 2016 levels, it wouldn't be enough to make a difference anytime soon. Supply would continue to exceed demand and inventory levels expand even if a freeze was implemented.

Now that the number of participants are dwindling, and Russia hinting about the possibility of there not even being an April meeting, it is easy to see there is a lot of contention happening behind the scenes, which points to things going on as usual. That means to me, even if there is something put on paper, there is little incentive to adhere to it, as has been the case with past agreements.

Impact of Libya

Libya is important in regard to the attempt to come up with a production freeze primarily from a psychological point of view. It is working on improving its security after the 2011 civil war, when it produced 1.6 million barrels per day. Currently it produces on 400,000 barrels per day.

Essentially Libya is saying the same thing Iran is saying: It's not going to agree to any production freeze until it regains its prior output level. In the case of Libya it's pre-civil war levels, and in the case of Iran, it's pre-sanction levels.

As it relates to the proposed production freeze, with Libya and Iran not participating in it, and representing a lot more supply coming to market over the next year, it makes the idea even weaker than it was under the most optimal conditions.

If Kuwait follows through with its demand all major competitors must agree to a freeze if it is to participate in the agreement, I don't see why the idea continues to be floated around. In the end, if this continues to unravel, as it obviously is, it will be worse than letting the market work things out, as Saudi Arabia has rightly stated would be the best course to take.

Iraq wants all to agree as well

Iraq has been producing at record levels recently, and has also said it has no interest in an agreement if all the major suppliers don't participate in a freeze.

As of February 2016, Iraq was producing 4.7 million barrels per day, with 4 million barrels targeted for exports. It has a goal of increasing that to 6 million barrels per day by 2020. I don't believe anything outside of market forces will change that.

source: Bloomberg

So we're back to the premise of whether or not a production freeze is viable or only an attempt to prop up the price of oil to buy producers some time while waiting for the market to rebalance on its own. My thought is it is not viable at all; not only based upon the lack of unity of purpose, but even if it were to be implemented, it would take a significant amount of time to work through the growing inventory before it started to have an impact. Even under those conditions supply would continue to exceed demand based upon January supply levels.

The slowing pace of global demand for oil means it'll take longer than expected for it to catch up with supply.

Iraq is one of those countries that I believe will continue to do what's best for itself, whether it signs an agreement or not. Russia is another.

Russia and the proposed freeze agreement

Besides Saudi Arabia, Russia is the next most important player that would need to agree to a production freeze. The problem there is Russia has been historically notorious for ignoring production cut agreements. Why that would change now is unclear and uncertain.

A recent comment from Russian Energy Minister Alexandar Novak has cast further doubt on the process itself. He said of the meeting itself it will "probably" be in April. That suggests there is a lot of turmoil beneath the surface that hasn't yet made it to the media. He wouldn't have used the word 'probably' unless there were real doubts associated with a freeze agreement.

Again, the issue is the impact a non-agreement would have on the price of oil after participants allowed the freeze to be grabbed by the media, which has been running with the story in a far more positive manner than is warranted.

It has helped in the short term, as investors have ignored the underlying fundamentals and are pushing up the price of oil based mostly upon a production freeze providing a floor to the price of oil, which could ultimately lead to a production cut agreement. A cut in production is never going to happen, but that's what is being touted as the scenario being played out.

Russia is amenable to a freeze agreement, but it appears it is not viewing the upcoming meeting, if it takes place at all, in a positive manner.

Iran factor

Past meetings and the proposed freeze agreement were centered around whether or not Iran would participate in it or not. It has been very clear with its comments that it is not going to freeze its production. That has caused some competitors to backpedal and say a freeze doesn't need to include Iran.

A freeze without Iran isn't a freeze. It's going to continue to increase supply, and I don't believe its competitors are going to idly sit by with an agreement in hand while it takes share away from them. It would also frustrate the purpose of the freeze, which is to at minimum give the impression inventory levels are going to start to subside.

It is clear to me now that Libya has thrown in its hat on the 'no agreement to freeze' side of things, OPEC and Russia can't spin that it can go forth and have a meaningful impact without Iran. It's also clear there is growing dissension among those being asked to freeze production under these conditions. From Russia's comments, it looks like the meeting in April is in danger of being canceled for these reasons.

Conclusion

While the Financial Times cited an OPEC delegate, saying, "There is agreement from many countries to go along with a freeze - why make it contingent on Iran," it can no longer be considered the only country with reservations and total resistance to the idea. Even though Saudi Arabia will probably agree to a freeze with or without Iran, there is not longer a guarantee others will now that Libya won't even go to a meeting in April if it takes place.

Even if a production freeze agreement were to be entered into by some countries, based upon January supply levels it would do nothing to deal with the oversupply situation. The purpose of the freeze was never to do so, but to give the hope to some it would eventually lead to a production cut, which is what would be the only real step taken that would legitimately be a reason for the price of oil to go up.

Whatever original outlook competitors had with a freeze agreement is no longer in play, and if one emerges at all, it'll be much weaker than anticipated. I believe the market is starting to understand this, and it will take something else to push up the price of oil over the long term.

My major concern is investors are treating the proposed oil freeze agreement far too seriously. To take positions based upon it having a serious long-term effect is a recipe for disaster. My thought is the bulk of it has already been priced in, and those investors having enjoyed some good short-term profits should seriously consider taking them off the table; or at least take the original capital used for the investment off the table if it is believed there is still more for the price of oil to move up in the short term.

Risk versus reward is shrinking, and with a production freeze being priced in, to maintain short-term positions could result in losing a lot of the gains. Some are counting on the price to surge before the April meeting, but as Russia insinuated, a meeting may not occur. Under that scenario I believe oil prices would pull back significantly.

The longer the process has went on the more the potential associated with the production freeze unravels. Even now it's not what was originally wanted, being thwarted by additional supply from Iran and Libya. In the short term Libya isn't as important, but when combined with Iran's output over the next year, it will offset any benefit of a production freeze. It will also contribute to the strong probability few participants would adhere to the agreement while competitors continue to grow supply.

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.