OPEC Speaks - Putin Wins

by: Andrew Hecht

Deal or no deal?

The devil is in the details.

Crude oil reacts.

U.S. production is going to increase.

The Russia effect.

The vast majority of market participants doubted the ability of the international oil cartel to agree on anything, much less and agreement to cut production. In the days leading up to the November 30 biannual meeting, it began to appear that the framework for a deal discussed in Algeria back in September was falling apart. The Saudis stated that they would not agree to any deal where all members of OPEC did not participate. In the background, the Russians worked to soothe egos and smooth over disputes.

Meanwhile, as the OPEC meeting approached the biggest sign of the dubious nature of market participants for the prospects for any deal was open interest in the NYMEX crude oil futures market. As this metric that measures the total number of open long and short positions increased above 2 million contracts, it appeared that speculators were placing bets on a continuation of the same from the cartel, rhetoric but no concrete deal.

In my article on Seeking Alpha on Tuesday, November 29, I wrote: "At each of the biannual meetings since 2014, the market has held its breath for some supportive action from the cartel. However, each time OPEC disappointed oil bulls. This time, their backs are against the wall as they convene, there are three reasons why inaction by the cartel could mean oil will break below the $40 level."

Deal or no deal?

On November 30 OPEC did something it had not been able to accomplish for years, the cartel announced a 1.2 million barrel per day production cut that will take effect in January 2017. As I had opined, Saudi Arabia shouldered the majority of the cut, agreeing to lower daily output by 486,000 barrels. After the announcement, that sent oil futures higher, the Russians committed to a 300,000 barrel per day decrease in production but OPEC said in their statement that they intend to persuade the Russians to double their commitment to 600,000.

The engineering of the deal is likely the result of Russian influence and horse trading. Saudi Arabia had said that they would only agree to an accord if all other members of the cartel contributed. Iran, a stumbling block for the Saudis, agreed to freeze output at its current level which is a major coup for the theocracy which is a close ally of the Putin government.

It appears that some aggressive arm twisting by the Russians resulted in the deal. Mr. Putin can now take a victory lap as his stature and influence in the Middle East will increase. It was no easy feat to herd those OPEC cats and the Russian leader stood behind the concept and in the end, achieved a positive result. However, as with any deal the market will have to wait and see if the cartel will stick to its words in the statement.

The devil is in the details

OPEC has not yet released the exact production quotas for members and there is always a potential for cheating by the members. OPEC is likely to depend on an honor system which could produce dubious results. However, the deal is a first for the cartel who have now thrown in the towel officially on a strategy of flooding the market with oil to chase away North American shale output and build market share. We must remember that after the OPEC cut, the cartel is still producing two and one-half million barrels more each day than it was two years ago. The flood has lessened which is not a result that the market expected. Many market participants went into the OPEC meeting short as most speculators bet that the cartel would not come to any agreement.

Crude oil reacts

Crude oil futures reacted to the news from OPEC as shorts scrambled for an exit from their positions. Source: CQG

Active month January NYMEX crude oil futures settled at $49.44 per barrel on November 30 in the wake of the OPEC meeting, a gain of $4.21 per barrel on the session. On December 1, it was trading at the $51 per barrel level. The technical test for crude oil is now at the October 10 highs of $52.74. While NYMEX futures traded to highs of $49.90 which was a gain of $4.67 during Wednesday's session, Brent crude oil, the benchmark crude for Middle Eastern production rose to highs of $52.36 on the February contract. On December 1 Brent was above $53.50 per barrel. The Brent premium over WTI is now around the $1.60 level in February. If crude oil continues to gain, expect the Brent premium to increase over coming sessions.

Open interest stood at 2.074million contracts as of November 30, a record high for the metric, and it is likely that short-covering over the coming days will lift the energy commodity higher, perhaps above the $53 per barrel level and maybe even close to $60 on the nearby NYMEX contract. Energy stocks rallied after the announcement of the deal with the Energy Select Sector SPDR (NYSEARCA:XLE) moving $3.65 or over 5% higher on the session to close at $74.48 on Wednesday. Higher oil will be supportive of the U.S. stock market as so many companies that trade in the indices are related to the oil and energy patch. However, above $50 expect an increase in output from the United States, the target of OPEC's abandoned strategy. Watch those rig counts start to climb!

U.S. production is going to increase

The President-elect of the United States ran on a platform of energy independence for the nation. Fewer regulations will result in a lower production cost for U.S. producers and crude oil will once again flow from the shale regions of the nation, particularly if the price moves north of $50 per barrel.

However, demand may also support a higher price for oil in 2017. Another pledge from the new President is to rebuild infrastructure in the country and that project will increase demand for all industrial commodities including energy. The incoming Treasury secretary expects the U.S. economy to grow at 3-4% in 2017 which will increase the demand for oil.

I have been writing that below $40 in crude oil capital expenditures dry up and above $50, U.S. crude begins to flow once again. However, it will be the demand side of the oil market that is likely to determine the path of least resistance for the price in the coming months. OPEC took the first step in fulfilling their mission to "stabilize" the price of petroleum and provide a " steady income to producers and a fair return on capital for those investing in the petroleum industry." With OPEC production still above the level where it was two years ago, there could be room for additional cuts by the cartel in the future now that the Saudi's have capitulated. Additionally, the upcoming IPO of Saudi Aramco means that a higher oil price is in the best interest of the Kingdom and they may be willing to consider additional cuts as they prepare to partially divest from reliance on oil revenues in the months ahead. Meanwhile, the biggest winner on Wednesday was Vladimir Putin.

The Russia effect

Most analysts believed that an OPEC deal was a pipe dream. After all, the relationship between Saudi Arabia and Iran has been spiraling downward in recent years. The two nations continue to fight a proxy war in Yemen and the theocracy in Iran would like nothing more than to overthrow the Saudi Royal Family.

Iran's influence in the Middle East has been on the rise since the nuclear non-proliferation deal and the country's engagement with Russia in Syria has forged a close alliance. Meanwhile, while Iran's power base has been rising Saudi Arabia's has been declining. The Saudis traditional support from the United States has become questionable. The nation strongly opposed the U.S. deal with Iran and President-elect Trump said that the Saudis would have to start paying for U.S. military protection in the future. Additionally, the U.S. Congress overrode a Presidential veto on a piece of legislation that allows for U.S. citizens to sue the Kingdom of Saudi Arabia over losses sustained on September 11, 2001.

The Saudi's have seen their monetary reserves fall over recent months as oil revenues declined with the price. Therefore, the Saudi's backs were against the wall at the OPEC meeting. As Russia is the other major oil producer in the world, Mr. Putin's support of a production cut by the cartel put him in a unique position mediate between Iran and Saudi Arabia and to influence the Saudis to get a deal done.

While many may look at the oil market as the big winner if the price of the energy commodity continues to increase, and I think that is likely, it is the Russian leader that comes out of Vienna with a historic victory. As OPEC spoke on November 30, Vladimir Putin's credibility on the world stage grew and his influence in the Middle East reached a new high. The success of the production cut will result in the producing nations in the region owing a debt of gratitude to the Russian leader. Mr. Putin, by his efforts and success with OPEC, has become the most influential world leader when it comes to the Middle East, the most volatile and energy-rich region in the world. The U.S. is also a winner as shale oil should start to flow again. The OPEC deal comes at a time when the world is preparing for a new beginning in the relationship between Russia and The U.S., perhaps it will be the era of Trump-Putin as the Russian leader said on Wednesday that he wishes to work with the incoming U.S. President on "equal terms" to restore relations. Mr. Trump loves a winner and Mr. Putin notched a big victory this week with OPEC.

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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.