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Why OPEC Will Follow Through This Time: Because Trump Is The New President

On November 30th, 2016, OPEC came to an agreement to its first cut since the 2008 financial crisis. Then, again on December 10th, non-OPEC countries also agreed to cut back on oil production, for an overall 1.2 million barrels a day (mb/d) oil production cut. This, as the Venezuelan oil minister has already called it, is "a historic agreement, one that's never been seen before." Oil prices have more than halved since 2014, when prices were above $100/barrel, due to the oversupply of oil and decreasing world demand. This single event of simply reaching an agreement to cut production has brought the US benchmark crude oil (NYSE:WTI) up from its low of $25 to $53.72/barrel, and Brent crude oil prices up from its low of below $40 to $56.82, as of Friday, December 30th, 2016. However, OPEC has been known to renege on their past deals, and so now, the question is, "Will they follow through?" And based on their rationale for making this deal happen in the first place, I believe they will.

This deal, which is now 2 years in the making, closed primarily due to one variable, in my opinion: Donald Trump. While the OPEC countries (and in particular, Saudi Arabia, which is an oil revenue-dependent country) were greatly hurt by the low oil prices, the financial pain was not enough to close the deal. The decision to come to a compromise was born more so out of the political need to put up a united front. Simply put, OPEC, of which 65% of its crude oil reserves are in Middle Eastern countries, is uncertain of Trump's future foreign policies towards them, and this uncertainty and subsequent fear of the future has led OPEC (and more so Saudi Arabia and Iran) to come to a compromise to get the deal to close and signal solidarity, and this same uncertainty is what will keep them in compliance.

Up until this year, this deal has always been thwarted by the conflict between Saudi Arabia and Iran. At 3.69 mb/d, Iran is the third-largest oil producing country in OPEC, after Saudi Arabia and Iraq. Saudi Arabia wanted to cut production because the low oil prices were hurting their heavily oil revenue-dependent economy, but required Iran to freeze production, however, needed Iran to agree to put the deal in place. Meanwhile, Iran would be willing to agree to an overall production cut, if it meant that it could increase its production volume to pre-sanction levels. Pre-sanction levels for Iran were at 3.975 mb/d, according to Iran, and that is the number they insisted upon when agreeing to this deal.

Additionally, if we look at the current total market share of Saudi Arabia in OPEC vs. Iran's market share pre- and post-sanction, we can see that Saudi Arabia has slowly been growing their market share, while Iran's has been diminished. This deal required Saudi Arabia to give up market share to Iran. As the table below shows, by yielding to Iran's 3.975 mb/d base output value for 2016, they have had to give up at least 1% of their market share. Had this deal not taken place, they would still have 32% of the market.

The yielding of market share was not the only factor thwarting the deal. There is significant animosity between Iran and Saudi Arabia due to their religious differences that continues to play a large part in their relations. In fact, if we look at the number of religion-related incidents in the past few years, we could see a significant upswing, which would only further prompt both countries to avoid a compromise.

Thus, of course Saudi Arabia wasn't willing to concede to Iran a greater share of the market and "lose" the negotiation, as it would signal weakness, and so the deal never came to fruition. Until Trump took office. Now, with no idea of what Trump may do their foreign relationships, they have decided to band together in a show of unity, to indicate that will stand with one another and support each other, despite their religious or economic differences, in the face of a new common enemy. By having significant control over a large part of the world's oil supply (40%), they will gain some form of leverage over the president-elect. Both countries have made significant sacrifices to get this deal done: Saudi Arabia gave up market share to Iran (by agreeing to their estimate of their current output and the 3.975 baseline pre-sanction levels) and conceded to their demand to increasing production, and Iran, although being granted the production increase (at 3.797 mb/d), is still not at pre-sanction levels. The following chart summarizes the current and post-cut production levels for all the OPEC countries.

And this investment and reconciliation of fundamental differences leads me to believe that they will also follow through on this deal. In order for this message of camaraderie to be effective, OPEC will have to follow through on its word, which is why the production cuts are coming, and oil prices will surge in the first quarter of 2017 to over $60/barrel. Additionally, these countries have learned the hard way what no production cuts and lower oil prices could mean for their futures and are not willing to take that risk again. Had Hilary Clinton been elected, Saudi Arabia would not have felt it necessary to band together with Iran to show power in the Middle East, as they would already know what to expect of her policies. The low oil prices might have continued to hurt them, but they would not be willing to come to a compromise that gave the Iranians what they wanted. It is the uncertainty of Trump's policies that has led them to this.

OPEC and non-OPEC members have already begun notifying their customers of shipment cuts, which provides some evidence, and this pattern will continue to hold, until something drastic happens, at least for the next 6 months.

Disclosure: I am/we are long XOM, XLE, RIG, WFT, HAL.

Additional disclosure: I strongly believe in the above analysis, which is why I have long positions in the above stocks/options.