OPEC Announcement Sets The Table For Bringing Stability To Oil Prices

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Summary

The market is responding favorably.

We expect oil prices will likely hover around $50 per barrel as the global oil markets keeps its eye on OPEC's adherence to its new stated quota.

U.S. producers are poised to benefit.

Tortoise's Take On OPEC Meeting

The 171st OPEC meeting concluded with the members formalizing the terms of the Algiers Accord. The agreement sets a production ceiling of 32.5 mb/d, representing around a 1.2 million barrel per day production cut, effective January 1st, 2017. In addition, an understanding was reached with key non-OPEC countries including Russia that results in a reduction of 600,000 barrels per day of production. A monitoring committee composed of representatives of Algeria, Kuwait, Venezuela and two participating non-OPEC countries has been established to monitor compliance with the agreement. The initial term of the agreement is six month but is extendable for another six months depending on prevailing market conditions.

A majority of the OPEC members will participate in the production cut. However, Saudi Arabia is projected to cut almost 500,000 barrels per day representing 41% of the total cut.

Market is Responding Favorably

In response to this announcement, oil prices are trading meaningfully higher today with WTI prices approaching $50 per barrel. For now, we view OPEC as relevant again as OPEC members move past their political differences and focus on economics. The reality is selling 10 million barrels a day of oil at $50 per barrel generates substantially higher annual revenue for Saudi Arabia than selling 11 million barrels at $35 per barrel.

Expected Impact to Oil Prices

What does this mean for oil prices in the short term? Over the next few months, we expect oil prices will likely hover around $50 per barrel as the global oil markets keeps its eye on OPEC's adherence to its new stated quota. Given OPEC's recent history with quotas, we believe it's appropriate for the market to force OPEC to prove it is serious this time. From a fundamental perspective, we expect OPEC's production cut will help bring global oil inventories back into a more normal range. Recall that for the last few years, global inventories had been extraordinarily high and global oil supply exceeded demand. With the OPEC agreement, this equation should be reversed with global demand exceeding supply and the result will be falling global oil inventories.

How about a long-term price impact? We anticipate oil prices will likely remain range-bound between $50 - $60 per barrel over the next few years. We believe this is a real sweet spot for oil prices as global oil demand for oil related products will continue to grow while low cost oil producers earn adequate returns on capital.

U.S. Producers Poised to Benefit

As oil prices fell, U.S. producers identified ways to lower production costs. U.S. producers have been successful in lowering costs to drill oil wells as well as increase the volume of production from wells drilled. The result is that the U.S. oil producers are now competitive in the global oil markets. In fact, some U.S. producers produce oil at a lower cost than a few OPEC members. As oil prices have increased and stabilized at $45 per barrel, some Permian basin producers have discussed increasing capital expenditures resulting in higher production volumes in 2017.

With today's announcement, we expect Permian producers to carry forward with their plans to increase capital and drill more wells in 2017. Other U.S. oil producers will likely adopt a wait and see approach ensuring that oil prices remain above $50 per barrel for at least six months before committing to increasing capital expenditures. Even with Permian Basin producers increasing capital and production volumes, we do not expect the U.S. to materially increase production volumes in 2017.

In summary, we feel OPEC's announcement sets the table for the energy sector bringing stability to oil prices, and OPEC is relevant again but its compliance with the new stated production quota is key to bringing global inventory levels back in-line with historical levels. Despite OPEC's production cut, OPEC's spare capacity remains tight; therefore, low cost U.S. oil production is expected to be a critical supplier as future demand for crude oil rises.

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. I have no business relationship with any company whose stock is mentioned in this article.

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