By Kirk Spano
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Since the December OPEC meeting, I have come to one inescapable conclusion: that OPEC will never cut production again at the expense of its own market share. Based on that idea, in the past couple of months, my clients, subscribers and I have done well to trade around oil's further decline, the slow bleed out of indebted oil stocks and even bet against a few banks. In the past week, however, oil has shown some strength on the back of young traders and short covering. With huge resistance around $37 per barrel of oil, I don't see that strength lasting long.
Back in late 2011 I identified — at about the same time that several institutions did — that the U.S. shale industry was going to change the global energy dynamic and recommended buying oil stocks. By 2014, I recognized that the price of oil would collapse, suggested selling oil stocks and invested in the dollar. In 2015, I made the same mistake that T. Boone Pickens admitted to recently, in that I, too, believed the rebalancing of the oil market would happen much faster than it has. The result was that I gave back a lot of 2014's gains.
The end of Saudi subsidies
But now times have changed again. Here are my reasons for OPEC’s actions. First and foremost is a question of logic. Why should the lowest-cost producers of oil subsidize the highest cost? In what we know is the beginning of the end of the oil age, it simply doesn't make any sense to let the highest-cost producers survive when the entire oil industry is slowly gliding toward a form of long-term business run off. It is not in the interest of the low-cost producers to cut production when the market will eventually kill the high-cost producers.
The International Energy Agency also just came to the same conclusion: "In 2016, we are living in perhaps the first truly free oil market we have seen since the pioneering days of the industry." If that's the case, low-cost producers will produce as much as possible from here on out. Oil-price increases will come from lower output from higher-cost producers who can't finance questionably economic new projects going forward in most cases.
Saudi Arabia has no intent to cut production. Their freeze agreement with Russia and a few others is simply an acknowledgment that they have reached the point where they want to be. Anybody who listened to or read Crown Prince and defense minister of Saudi Arabia Muhammad bin Salman's interview in January ( The Economist ) should have no doubts about his resolve. He realizes the power of the kingdom's oil and is going to use it.
One clear sign that Saudi Arabia has no intention of cutting production is the likelihood that they are taking Saudi Aramco public. By doing this, Saudi Arabia can claim that they are not in control of oil production, the same way that Russia and western nations do when they point out their oil companies are privately owned. By taking Aramco public, the Saudis can take a windfall and create a cash-flow machine for the royal family and the country (presumably). I could see a small cut in Saudi oil production just ahead of taking Aramco public to goose the IPO, but not likely before then.
What about the other players?
Iran has stated that they will increase production by a million barrels per day over the next year. While they probably miss on that target, there is no doubt they are on a path to much higher production. The rest of OPEC will never cut to offset Iranian production entering the market over the next two years when higher-cost oil will die anyway.
Iraq, while they have signed off on the freeze, is only partially signing off. The Kurds in the north, who operate independently (though maybe not completely legally), are not going to stop increasing oil production short term. Longer term, Iraq is unlikely to hold the line as they need more revenue to rebuild.
Libya is over a million barrels per day below their normal production due to the civil war there. At some point, that production will come back to the market, as they too will need to rebuild.
Non-OPEC adjustments
So, over the next year or two, there is virtually no chance that OPEC cuts production. After that, they might cut production slightly to maintain pricing, but not at the expense of market share. We will continue to see the adjustments to supply come from non-OPEC higher-cost producers depleting assets and not reinvesting. OPEC will not only keep their market share, they will increase it by a couple of million barrels most likely. I've come to agree with those who think the oil market won't clear until the price of oil hits $20/barrel or lower for a day or two — likely sometime this spring, in my opinion — and trades in a range of $25 to $45 for a period as the National Bank of Abu Dhabi PJSC recently suggested.
For investors, the idea of value hunting in the oil space has become slightly more popular lately, particular betting on a rise in oil prices. The Velocity Shares 3x Long Crude Oil ETN has been among the most active vehicles of late. It is a very risky bet in my opinion, as the long-term trend is against it. Traders using that fund are betting on a reversal that is probably not here yet.
Disclosure: Kirk Spano and certain clients of Bluemound Asset Management do not own any security mentioned. Subscribers to Fundamental Trends have no recommendations to buy any security mentioned. Neither Spano nor Bluemound clients plan any transactions in the next three trading days. Opinions subject to change at any time without notice.
