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Why Isn't OPEC Considering A Deeper Cut?

|Includes: The United States Brent Oil ETF, LP (BNO), OIL, USO

Summary

Because it won't work.

What would happen if OPEC decides to cut deeper?

Conclusion: let Adam Smith do the job.

Introduction

Oil prices are in trouble. OPEC has taken most of the blame for not implementing deeper cuts and hasn't given any indication to do so, on top of the fact that Russia has recently said no. Why not? The answer is simple: because it won't work.

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What has OPEC done so far and how did the market react?

  • November 30, 2016 - 1.2m bpd output cut for the first half of 2017. 
  • May 25, 2017 - 1.8m bpd output cut for another 9 months until March 2018. 

As expected, oil prices initially reacted positively and rallied to as high as $55 WTI, but the optimism turned out to be a quick one as soon as we saw prices in June 2017 plunged by 20%.

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Why? Because other countries have been filling the gap. 

Libya and Nigeria, both exempt from the cut deal are reported to be collectively pumping well over 1m bpd. Iran is looking to boost production from 3.8m to 8m bpd. Oh, and we must not forget the United States of America.

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What if OPEC decides to increase its cut deal to 5m bpd until the end of 2018? Here's how things may play out:

  1. WTI prices rally to above $55 in reaction to the good news as the market has a strong tendency to get ahead of itself.
  2. Big banks revise their WTI forecasts to above $60, perhaps even higher.
  3. The media publishes optimistic outlook for oil, sending investor sentiment to positive territory. Analysts claim the glut issue is finally over and someone dying for attention will pioneer wild estimates of $80-$100.
  4. You probably guessed it. Countries that are not participating in the cut will get right back to pumping if not already, especially the US producers who can profit quite handsomely at prices above $50.
  5. Output, inventory and rig counts begin to pick up as companies all over the world fight for market share, which inevitably creates yet another supply glut. Did someone just say cheating amongst OPEC members?
  6. Prices fall back to below $50, $45, $40, you pick your number this time.
  7. The market points its finger at OPEC for not doing more. Sound familiar?

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Just for your entertainment, here’s another version:

  1. Investors yarn, because they have learned that someone else will just fill the gap again this time.
  2. Prices suffer another round of sell-off, tumbling to sub-$40 territory.

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Conclusion

Long story short, the important thing to understand is that OPEC is no longer a price-maker but a price-taker. It’s a global market where there are simply too many players trying to eat from the same pie. If OPEC doesn't pick up the spoon, someone else will. Therefore, I'm afraid we will just have to rely on the invisible hand of Adam Smith to do the job of rebalancing the market.