Are Oil Producers Playing A Game Of Chicken?

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Includes: USO, XLE, XOP
by: Markos Kaminis
Summary

OPEC just acted to extend production curbs.

U.S. producers extended their streak of production increases.

Is this a game of chicken, and if so, who will blink first?

I suggest there will be no loser, as the price of crude improves on other factors.

The North American rig count and U.S. oil production keep rising. Yet OPEC just met and agreed to hold production quotas steady in order to bring oil supply into balance. So are U.S. producers banking on OPEC and major non-OPEC producers blinking when/if oil prices get even cheaper? Likewise, is OPEC counting on U.S. production stalling on price pressure? Are U.S. and OPEC oil producers playing a game of chicken? Maybe, or maybe all parties involved are just testing the market for price equilibrium. In the end, I believe there will be no loser, as oil prices gain on other factors.

According to Baker Hughes (NYSE: BHI), U.S. drillers increased their rig count by six last week. At 747 oil-only rigs operating in America, U.S. producers such as (NYSE: XOP) are now running at capacity not seen since April 2015. Furthermore, it was the 22nd consecutive week of increases in rigs for crude oil (NYSE: USO), which marks the longest streak in 3 decades.

But U.S. producers are increasing drilling at the same time Middle Eastern and other OPEC and non-OPEC producers are putting a lid on their own activity. It's a coordinated effort by most of the world's major producers to bring global inventory down to the 5-year average.

When the consortium met in May to decide what to do about their expiring production plan, I told investors to sell the news unless OPEC expanded its production cuts. Oil prices fell about 14% thereafter, because OPEC simply extended current quotas for another nine months.

More recently, after the drop, I suggested oil prices looked accommodating again to new investment. Some of my reasoning was based on an understanding and reliance on industry dynamics to work themselves out. At some point lower prices inhibit new U.S. production; likewise, at some lower point, OPEC probably does something more to stabilize and support pricing. But who will blink first and how much pain will come to the market until then?

The global economic crisis played a role in creating the imbalance, and improving global economies should help draw down inventories in the second half of this year. However, some are starting to wonder about that, given U.S. production keeps increasing.

Increased U.S. production (NYSE: XLE), supported by technological advances and our ambition for energy independence, has played its significant part as well. The International Energy Agency, in its Oil Market Report, just indicated that it expects burgeoning production to outpace demand in 2018. That could be a problem if supply is not balanced by then.

My rhetorical question regarding who will blink first and when might not need to be answered. At some point, somebody would blink, whether it be U.S. producers on unprofitable pricing or OPEC and Russia for various other reasons. Saudi Arabia certainly has its reason, with the IPO of Saudi Aramco looming.

This equilibrium price discovery effort, or game of chicken, may end up with nobody losing. In fact, that is my expectation. First, because I expect global demand to be better than most economists foresee, with recovery in Europe and a pickup in the U.S. in my purview. Second, I like oil here because geopolitical risks are rising.

The always volatile Middle East is now earning a new place in the situation rooms of far too many organizations and nations. Based on my observations around President Trump's visit to the Middle East and following developments, it appears the tinder box is getting hotter. In the last 24 hours, the United States felled a Syrian jet, Saudi forces foiled a terrorist attack on an offshore rig, and Iran launched missiles into Syria, targeting ISIS forces.

I believe the developments around Qatar mark the beginning of a new U.S. engagement of Iran. Whether Qatar is mitigated quickly or not is likely of no matter in my view. The pressure on Iran is only going to increase given the more engaging foreign policy of the new U.S. Administration, in my view. And now, Iran's enemy across the Persian Gulf, Saudi Arabia, has been emboldened. I believe it is only a matter of time on a quickly ticking clock before we have an event catalyst for higher oil prices.

In conclusion, increasing U.S. oil production offsets OPEC production curbs as eastern and western producers play their roles in equilibrium price discovery. The global economy and recovery of integral regions (Europe) could surprise many forecasters. Geopolitical risks have been attributed too low a factor weighting in an environment that seems to me to show risk intensifying. In this game of chicken, I see no loser, because the rules of the game are changing. For more of my views of markets, readers are welcomed to follow the column here at Seeking Alpha.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in USO, XOP over 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.