OPEC And Russia Can't Control Or Manage The Oil Market

| About: The United (USO)
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Market demand for oil will determine prices over the long term.

Price range strategy could backfire because of improvements in productivity and efficiencies.

Shale producers aren't all created the same.

Real purpose is time management, not price management.

Investors shouldn't look at this in the same way they have in the past with market management strategies.

Source: CNN

I continue to find it strange that energy commentators, analysts and pundits risk their reputations by continuing to make assertions concerning the proposed OPEC production cut as if the cartel has the same influence it has had in the past, even with the emergence of the powerful U.S. shale industry.

The problem is these old school "experts" are acting as if there hasn't been an extraordinary market disruption, and if OPEC and secondarily Russia, agree to a production cut, they can provide the market with a predictable price range, which presumably is between $50 to $60 per barrel.

OPEC, as far as I've been able to find, hasn't mentioned that price range, but it's probably an accurate reflection of what the cartel is thinking. The idea is it will continue to allow low-cost U.S. shale producers to be much more profitable, but keep the high-cost producers from ramping up production, even as their debt comes due in 2017. That means, collectively, U.S. shale producers won't be able to bring enough supply to the market to undermine a production cut from OPEC, and possibly Russia. This assumes there will be an actual and meaningful price cut beyond a verbal intervention level.

The truth is OPEC has no power to influence the price range of oil based upon actions it takes. Yes, it has driven up the price of oil based upon its announcement, but that's only because the market still hasn't figured out or understood it has no teeth behind the proposed deal. Investors have taken advantage of the momentum, but there isn't much left to justify the price of oil moving up further, as it has already been fully priced in.

OPEC can't influence the price of oil for the long term by cutting output. Its real reason for the announcement and possible weak production cut, is to buy the cartel more time for demand to climb enough for the market to sustainably push up the price of oil. That's really all that OPEC has left in it, and that is only relevant to this short period of transition where U.S. shale producers are completing wells and adding rigs.

That will take some time to implement, which means the full force of the additional supply won't have a full impact until many more wells are operational at the same time. OPEC knows this, and it's why the appearance of flexing its muscles has the same results as it has had in the past. That's an illusion. This will be apparent in my view, within about a 6-month period of time, as shale oil once again floods the market.

If I'm wrong on the time frame, it's still only going to be a temporary influence on the market. One way or another, a production cut will only have a temporary and limited impact on the price of oil.

What OPEC and Russia can't control

There are several obvious things OPEC or Russia can't control in regard to the oil market, and that includes the pace of the growth of market demand, low-cost U.S. shale production, and the supply level outside of the cartel and possibly Russia.

Now that the shale industry has been established in the U.S., there is nothing that can be done to remove the barrels of oil from the market, other than forcing high-cost producers to lower production levels. The quality shale producers can in no way be slowed down or stopped, and they're consistently adding rigs and completing wells because they can generate a profit even with oil in this price range. The stronger competitors can make money even when the price of oil is at $40 to $45 per barrel. OPEC can't stop them from increasing production and making money.

On the demand side, no company or entity can slow down global consumption, and it's going to continue to grow for many decades into the future. The only question is at what pace it will grow because of periods of slow economic growth and recessions.

With a recession almost guaranteed to occur within the next several years, there will be a reduction in the pace of demand for oil, and that will upset a lot of projections that aren't including a recession in the models.

Concerning supply, OPEC has a mixed ability to influence that, based upon production levels. Again, that is only a temporary influence it has because of the transitory state of the shale industry, by which I mean the time it takes for shale producers to bring their full portfolios to bear on the market within the parameters of their production strategies and goals.

OPEC has no control over any of this, and these are the fundamentals and catalysts within the market that count.

Shale producers will counter and frustrate OPEC's efforts

One of the reasons U.S. shale production isn't being considered the strong countermeasure to OPEC's proposed output cut as it should is because of the mixed quality of the companies within the sector. There are a number of companies that can easily generate a profit where the price of oil is now, and others that are still relying on the price of oil to climb before they meaningfully boost supply.

A major part of the shale industry not being taken into account is the increase in productivity and efficiency that has resulted in stronger performances from a smaller rig and well count. The truth is we really have no idea how the relatively modest increase will have an impact on U.S. supply. With the shale industry holding up strong with the collapse of the number of rigs in use, it points to vast improvement in productivity, which in my opinion has a very strong chance of surprising to the upside. We'll get more visibility once the earnings reports come in.

My belief is shale production is going to thwart the attempt by OPEC to cut production in order to support oil prices. That would mean shale producers will take market share from OPEC and maybe Russia, which would result in a quick decision to rescind the agreement. Either that, or as in the past, it'll just be ignored by the participants in the meaningless deal.

The U.S. shale industry is here to stay for the long term, and will in the near future become the top oil producer in the world. It is already the swing producer, which generates the question of why so many investors are rising the media frenzy of an OPEC that has taken up its past mantle, when in reality it has no ability to do so. This is an illusion that will be burst. Hopefully, it's before naive investors are crushed from the belief OPEC can support the price of oil for the long term. The U.S. shale industry has already proven it can't.

Production cut is really a time management strategy

If a real production cut does take place by OPEC and Russia, it shouldn't be considered anything more than a time management strategy. By time management I mean an attempt to support the price of oil over a short period of time while demand catches up with supply.

As shown earlier, OPEC has a very limited period of time it can impact the price of oil, and this is really where any legitimate production cut would have value.

The time management aspect of this is in connection to the temporary slowdown in shale oil production where it'll take time to ramp up production to offset a decline in OPEC and/or Russian output. It has no value as a long-term solution to weak oil prices.

That said, it's still very questionable even as a short-term benefit if it's worth the risk. Ceding market share while losing momentum isn't necessarily something OPEC could immediately remedy, even though with some members they can quickly boost production. Someone is going to buy oil, and it doesn't matter who it comes from if the price is competitive. There is no guarantee the vacuum from the cut in output won't quickly be filled by competitors looking to gain market share.

Keep in mind that eventually demand will catch up with supply, so if a company can win and hold market share in the near term, it has a chance to maintain that business over the long term as prices rebound based upon market conditions rather than interference in the market.


Where the risk on the part of OPEC and Russia resides is if they've underestimated the ability of low-cost shale producers to increase production and quickly offset a cut, which would eliminate the purpose of the cut in the first place. OPEC is trying to buy time for demand to increase in order to rebalance the market. Its assumption is it is able to do that without suffering any short-term pain. I believe it's wrong.

That isn't to say there won't be a short window of price support for oil while shale producers rush to bring more oil to the market, because that will happen if a production cut is put in place. What I'm saying is those cuts will only have a very limited, short-term impact on the price of oil. The depth of that will be determined by the specifics of the deal. Looking at recent responses from various member states and Russia, it's not going to be a meaningful deal that has any teeth in it.

Oil is being set up for a correction because there is nothing in the market or the proposed production cut, as we know it now, that justifies the recent big upward move in the price of oil. I don't believe there will be any surprises on the production side where Saudi Arabia decides to take a big cut in supply in order to placate weak competitors.

It has been willing to offer the perception of a cut in output because of the seasonal timing of the announcement, which lines up with its annual period of shrinking domestic demand. But to think it's going to do a lot more than that is to not understand what is really happening with Saudi Arabia and its historical practices.

I have a bullish outlook for oil over the long term, but in the short term, including this alleged production cut, it will have little impact on where the price of oil will go. After November that will be very clear to the market.

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.