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Oil Approaches A Watershed Moment In Vienna

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Includes: AOIL, BNO, DBO, DTO, DWT, NRGD, NRGO, NRGU, NRGZ, OIL, OILD, OILK, OILU, OILX, OLEM, OLO, SCO, SZO, UCO, USAI, USL, USO, USOD, USOI, USOU, UWT, WTID, WTIU, XOP, YGRN
by: Fluidsdoc
Fluidsdoc
Long only, value, Growth, contrarian
Summary

OPEC+ gathers in Vienna for its end-of-year meeting next week.

Will they or won't they extend or even increase cuts into next year?

KSA is running out of patience with quota cheaters, and by extension the merry shale frackers in the U.S., in their stated goal of balancing the oil market.

Are we about to see a repeat of 2014?

Introduction

The markets, jittery as ever on Friday, took to heart rumblings coming from the attendees of the bi-annual summit in Vienna. The oil price tumbled as a result, dropping 5% in a single day to finish just above $55/bbl.

Here's the issue for Riyadh. KSA has shouldered the brunt of the cuts - which, given their position as OPEC's nominal leader, only makes sense. But the pain is there nonetheless. Even worse, the strategy of cutting to balance the market has been only marginally effective, thanks to the "cheaters" and, of course, the undisciplined shale frackers in the U.S.

KSA has replaced the former long-serving oil minister Khalid Al Falih with a member of the royal family - Prince Abdulaziz bin Salman (ABS). Noteworthy in itself, as royals don't normally have "regular" jobs, because they're... royals. Now, ABS isn't your typical yacht cruising, Cristal swilling royal. Carrying substantial credentials, he brings lot in the way of education, experience, and past service this new position as the oil minister. In short, ABS is the real deal, and he's just gotten the job he's probably dreamed of for decades. He is now the mover and shaker in the oil business in KSA - the oil minister. My bet: he will change course from the cut, cut, cut strategy if a reasonable expectation of more equitable cut sharing is not achieved. I further expect he has a mandate to do just that, as we will discuss.

And that change in strategy, should it come, could have some interesting ramifications for the oil market.

Let's take a trip back to 2014

Oil was +/-$100/bbl, and OPEC's share of the global oil market was falling. In a surprising move, KSA refused to drop production to balance the market, and oil swiftly fell to around $50/bbl by early 2015. It kept dropping as the supplies of oil filled up every teacup and kettle around the world - not stopping until early 2016, when it reached a low of about $26/bbl. Once shale frackers had begun to cut their budgets and deepwater capex was disappearing from the market (only two of KSA's many goals), there began to be whisperings from KSA about an output freeze to shore up prices. This was enough to form a bottom, and the oil price began to rebound. Of course, in the intervening years, KSA has found it necessary to impose actual output cuts upon itself and other OPEC members to keep prices in the $50-70 range it has occupied for much of the time. It's even corralled Russia into cooperating in this effort.

Which, of course, brings us to the meeting next week. Time has flown, but the oil price still languishes in the mid-$50s for WTI and low $60s for Brent. What are the major movers that could shift the course for OPEC next week?

Vienna, December 2019

(Source: Bloomberg)

The graphic above tells the tale of the tape. Saudi has carried the output cut "water" for OPEC in 2019, and further back if you wanted to look. The sheikhs have had enough, and my bet is the new minister is going to read other OPEC members the riot act.

As I mentioned in a non-public article last week, I cautioned about Russia, which has been overproducing about 70K BOPD and is wanting to add condensate to its quota. I bring my detailed concerns forward in this quote from that article:

Among other things, Russia wants to recalibrate how its cuts are measured. They are producing a lot of condensate with the gas from its Kovyata and Chayanda gas fields. For those who aren't aware condensate consists of lighter molecules resulting in a API gravity above 50. So far Russia has been counting this in its crude compliance tally, and wants to exclude them as they are already over-producing their quota by 70 K BOEPD.

- Daily Drilling Report Oil Trends Tracker, November 28th

This isn't going to set well with the Saudis, who are there to send an entirely different message - one of shared sacrifice in support of a common goal. It is a fairly tired refrain, and this is probably the last time they will try this tactic before shifting gears. There is an event on the near-term horizon that changes everything.

This could all be posturing by Russia, which wants to shore up its standing in the Middle East, if for no other reason than to further alienate America from one of its closest allies in the region - KSA. Relationships between the two have been strained since the Khashoggi affair, and Russia likes it that way. That said, Russia has a legitimate condensate problem and will try to walk a fine line. We'll see how that goes.

The Aramco IPO

The Saudis will likely announce the price of shares for this long-awaited IPO during the meeting next week. This is a watershed event. If you follow this blog, you have to be aware of this IPO. For the first time ever to raise money, the Saudis are selling off a small fraction, +/- 1.5%, of this foundational resource of the kingdom. Part of the problem has been valuation. How much do they get? That has been discussed ad infinitum over the past couple of years, and I'm not veering off into it here. The point is after the announcement is done.

With +/-$25 billion in hand, according to some estimates, the gloves will come off... and soon. It could be 2014 redux.

Your takeaway

The last time KSA was this frustrated, they opened up the taps and flooded the world with oil. Can they do it again? Undoubtedly. Saudi Arabia has the demonstrated capacity to produce +/-11 mm+ BOD. So, from present levels, they could probably add another 1 mm BOD fairly quickly. This would bring about a production free-for-all from the other members capable of producing more. Russia, for example, could certainly ramp up another 500k-1 mm BOD.

(Source: Trading Economics)

If they were do this, one thing in particular would happen. The oil price would crash back to or below 2016 lows in a matter of months, or weeks, depending on some activity of the other global uncertainties - trade, cash crunch in the Permian, etc.

One driver, in particular, make a reversal of strategy seem fairly likely, absent an agreement to stick to quotas coming out of the meeting.

  • North American shale is about to enter a period of retrenchment, but most estimates indicate that it is in a bottoming pattern with activity forecast to rebound moderately next year.

Why not set it back still further? There is a compelling strategy behind this notion. Shale production has been the bane of the Saudis attempt to get prices up in support of their economic goals and, of course, the Saudi Aramco (ARMCO) IPO we've just discussed.

Of the two primary things they accomplished in 2014-15, crushing shale drilling and deepwater drilling, shale has been reinvigorated. Deepwater is still largely dead.

Shale frackers (the service providers) are rapidly mothballing their pumps, the engines of fracking. Equipment that costs millions of dollars per unit is starting to bleach away in the west Texas sun, never to pump again. The sand suppliers have fared no better. In my view, we are approaching a cliff in terms of capacity to ramp up. After writing off billions in infrastructure, the service providers simply will not be able to support the capex to rebuild. So, as an adversary, Saudi has to be thinking: "Finish them off."

The rig count now headed toward a 30% decline YoY would be further smashed down. 50, 60, 80%... who knows? The point is the architecture of the shale miracle is in peril. In KSA's position, I know what I would do.

In summary, the plan this week is to sit tight. What is cheap may well get cheaper in the near future. I am not buying the market at present, as the volatility is simply too high to make an informed decision.

Buckle in. Take some antacid, and perhaps an anti-depressant. It could be a bumpy ride this week.

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.

Additional disclosure: I am not an accountant or CPA or CFA. This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended