I Told You So: Saudis See 'No Need' To Extend Production Cuts

| About: The United (USO)
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Summary

Surprise! Riyadh doesn't think it will be necessary to extend OPEC production cuts past H1.

Meanwhile, US producers are hedging in anticipation of the very price drop they're helping to facilitate.

If prices drop, what will inflation comps look like in 2018?

As I write this it's Monday morning before dawn and I've got cable on my mind. And not Time Warner or Comcast.

Rather, I'm knee deep in notes on the British pound. Sterling plunged overnight on "hard" Brexit fears and it's all I can do to keep up with the headlines.

But while scanning the wires for FX news, I ran across two complimentary stories about crude (NYSEARCA:USO) that serve to validate a thesis I presented here earlier this month. So, I decided to take a much needed break from "pound"ing the table on cable to talk about oil. This one will likely be short and to the point (for a change).

Earlier this month in "Oil: The Only Question That Matters For Crude Prices," I argued that when it comes right down to it, what really counts is how the Saudis appraise two things: 1) their own fiscal situation, and 2) the prospects for Iranian production. Here's an excerpt from the piece linked above:

We can debate the details, but at the end of the day, there's only one thing that matters. That is, this is basically all about how Riyadh views the trade-off between shoring up its own fiscal situation and creating more revenue for Tehran.

Higher prices help the Saudis close a yawning budget gap, but that has to be weighed against the fact that by driving prices higher, Saudi Arabia is effectively helping its mortal sectarian rival get richer at a time when the two countries are effectively at war both in Syria (where Riyadh's Sunni proxies are on the run in the face of pressure from Russia, Iran, and Hezbollah) and Yemen (where Iran's own proxy army, the Houthis, likely won't be able to hold out forever against the Saudi-led coalition that includes Qatar and the UAE).

That's it. That's all that counts. You may think there are other factors involved but if Riyadh has some kind of dramatic change of heart (with regard to either the kingdom's funding needs or how it should approach curbing Iranian influence in the region) and that change of heart leads to an unexpected change of policy, no one is going to care what that week's EIA or API numbers show or what the latest read on global demand says.

By extension then, oil prices are primarily a reflection of geopolitics. More specifically, they reflect the current state of the sectarian divide (Sunni/Shiite). Russia, by virtue of its own production and perhaps more importantly, Moscow's political ties to Tehran, is also a factor.

At this juncture, someone out there is probably screaming at their monitor and asking all kinds of rhetorical questions about US output, advances in technology, better economics for US producers at higher prices, etc.

Well let me tell you how the US plays into this. US producers are doing what they've been doing for years: trying to stay in business.

When prices were still in freefall that meant finding ways to raise capital (bond offerings, RBL lines, revolvers, secondaries, etc.). Now, with prices in the $50s, it's about pumping again. Either way, they're sowing the seeds for their own demise. That is, the very act of staying in business means contributing to the deflationary impulse either by preserving potential output (clinging to life by raising capital even if prices are too low to pump) or by actually pumping more oil (ramping up production when prices rise above ~$50/bbl).

In my assessment of the Saudi's position, I noted that the kingdom has had no trouble tapping debt markets; their $17.5 billion issue in October was massively oversubscribed and they're looking at selling Islamic bonds in H1. "Riyadh can finance at least part of the budget deficit without oil prices rising," I said, adding that "if [the Saudis] determine that going into debt is better than letting Iran get rich (and don't forget, Tehran is taking market share by default thanks to its exemption from the OPEC deal), then the incentive to stick to the cuts is commensurately reduced."

Ok, so that's the backdrop against which you should consider the following two headlines from Bloomberg:

You don't even have to read the stories to understand how they support my thesis.

"We don't think [extending the deal is] necessary, given the level of compliance we have seen and given the expectations of demand," Saudi Energy Minister Khalid Al-Falih said on Monday. "The re-balancing which started slowly in 2016 will have its full impact by the first half," he added. "All players have indicated their willingness to extend, if necessary, [but] based on my judgment today, I think it's unlikely that we will need to continue."

Those of a cynical persuasion might interpret that as follows: "given likely H1 debt issuance and the positive impact higher prices have already had on our finances, we'd rather not keep a floor under prices with Iran at 4 million b/d."

But Al-Falih insists it's all about avoiding a shortage. "We want to make sure the markets continue to be supplied well," he said. "We don't want to create squeeze, so the extension will only happen if there's a need, and if there's a a need, we will do it."

Forgive me for laughing.

Meanwhile, US producers continue to pump even as their hedging behavior seems to suggest they are well aware of the downside risk to prices. Here's Bloomberg:

Producers and merchants increased their bets on lower West Texas Intermediate crude prices to the highest level since 2007 as futures held above $50 a barrel. The increase in hedging against a price drop signals a comeback in U.S. shale output, just as OPEC members and other producers seek to reduce supply.

The U.S. oil rig count increased in 10 out of the past 11 weeks, according to Baker Hughes Inc. data. The EIA also reported that U.S. crude output rose to the highest level since April in the week ended Jan. 6, while crude stockpiles surged by the most since November.

Producers are "protecting themselves," Tariq Zahir, a New York-based commodity fund manager at Tyche Capital Advisors LLC, said Friday. "The production increase from the U.S. coupled with Libya's increases are really going to hit the market going forward."

So producers know what's going to happen, and yet they're ramping up production anyway - "make hay while the sun shines," as they say.

But when it comes to US production, my question is whether, once prices do head lower again, capital markets will still be open to producers. After all, they were down to their last lifeline (follow-ons) before prices rose. Investors should consider that.

Ultimately, all of the above suggests that rising prices aren't sustainable. From a macro perspective, that begs an important question (or two) which I'll leave readers to ponder: If prices do fall and that ends up putting pressure on Y/Y inflation growth in 2018, will central banks then have the excuse they need to rollback any tightening that takes place between now and then?

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.