How OPEC’s Attempt to Save Face Affects the Crude Oil Market

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Dr. Kent Moors writes: Just as I was finishing up Monday’s Oil & Energy Investor, information emerged that something was happening with OPEC. I made mention of it in a note appended at the end of that installment, finishing with the observation that it “Looks like somebody just blinked.”

Well, that somebody is OPEC, and there is much more behind this development, leading to today’s discussion.

In its monthly report released on Monday, OPEC indicated it is now willing to discuss production levels with other non-OPEC countries. This is the first indication that the low crude oil price environment has been creating serious problems inside the cartel.

However, this needs to be put in perspective. A “blink” is not “crying uncle.” And an op-ed piece appearing in the OPEC Bulletin is not a blanket statement of a policy change. But just the same, comments don’t find their way into this publication without the consent of the OPEC Secretariat in Vienna and the dominant Saudi presence within the organization.

The OPEC strategy of keeping production constant to maintain market share, even in the face of a precipitous decline in oil prices, has been unraveling for a while. As I have remarked in Oil & Energy Investor on numerous occasions over the last nine months, the approach has left the cartel seeing budgetary red ink.

Here’s what that means for OPEC’s production strategy… and the oil market as a whole…

How OPEC’s Strategy Fell Apart

As I noted in the last installment of Oil & Energy Investor, every OPEC member country is now running a budget deficit. Even the most solvent of the group – Saudi Arabia, Kuwait, and the United Arab Emirates – have been affected by this strategy. But the likes of Venezuela, Nigeria, Iran, Libya, and Ecuador are facing impending (or already existing) financial implosions.

For months now, the manner in which OPEC operates has been in disarray. The normal approach is for the Secretariat to estimate global demand and then deduct estimated non-OPEC production. What remains is referred to as “the call on OPEC.” That figure is then divided among members into monthly quotas.

However, with the exception of Iran (still laboring under Western sanctions) and Iraq (yet to be given a renewed quota from the cartel), each of the OPEC producers is now regularly producing (and exporting) well above its quota.

The reason is simple. Crude oil comprises the only revenue stream of any consequence. Therefore, despite the low prices, OPEC nations have had no choice but to exceed their quotas and sell volume into a declining market.

That is a recipe for pushing your own profits down at the same time as you drive oil prices south.

In a clear indication that the organization is experiencing disagreements from within, four of the countries (Iran, Libya, Venezuela, and Algeria) have publicly suggested OPEC should cut production, thereby providing an avenue for increasing prices. Nonetheless, the Saudis have been able to hold the line on production.

In fact, even the Saudis are now producing in excess. The rationale here is rather transparent. Riyadh can no longer prevent other OPEC members from overproducing. So by opening its own taps Saudi Arabia provides the pretense of a cohesive approach when actually there is none.

OPEC is now exploring an alternative approach to the market share competition. The cartel controls a smidgen more than 40% of global oil production. That means six out of every 10 barrels come from someplace outside OPEC.

What is now taking place are the first steps in an attempt to keep market share by entering into agreements with other producers. This has been attempted before with mediocre results. But this time, the last nine months may have taught the rest of the world a lesson that OPEC now wants to capitalize upon.

Why Saudi Arabia Is Looking to Russia for Help

Here’s what is unfolding. Contrary to the current theme among pundits, the immediate target of OPEC’s strategy is not American shale and tight oil producers. Rather, it is Russia. This has all the earmarks of an “any port in a storm” scenario.

Russia is the second-largest non-OPEC producer (U.S. now being the first), regularly sends observers to OPEC meetings, and has a line open to the cartel. However, it will never become a member for the simple reason that Moscow does not want other countries to dictate Russian production levels.

It has also been in direct competition with OPEC (the Saudis in particular) over access to the Asian market. All roads lead to Asia over the next several decades as the brunt of worldwide energy demand levels drives a path there.

In the early stages of OPEC maintaining production, the primary target was to bring the price low enough to make it unprofitable for Russian crude to move across the finished East Siberia-Pacific Ocean (ESPO) pipeline to Asia.

That was in large measure accomplished, although Russian volume is still likely to be increasing, longer term.

I am hearing that OPEC may be prepared to provide some Asian access to Russia in return for an “understanding” on volume. In return, pressure on prices may be relaxed.

Notice the usual suspect mentioned by analysts is noticeably lacking. The game changer in global supply levels has been U.S. unconventional production. But the shale patch is not at present represented in these fledgling talks.

The Threat of U.S. Shale Oil

Unlike Russia, there are two contrasting views held within OPEC about American production. One holds that it has only an indirect effect on prices because virtually all of it cannot be exported until Congress changes laws.

On the other hand, there is widespread belief within OPEC that the broad export of U.S. production is inevitable. This happens to be a view I share (as OPEC colleagues know only too well). If the volume is coming anyway, there seems to be added urgency in working out a more widespread understanding on monthly production.

Leading to the second overall point: U.S. production will be an ongoing factor. OPEC may hope that debt constrictions and domestic competition may wipe out some American companies. Yet those remaining will still prove to be a problem for the cartel, as the “call on shale” is beginning to replace the “call on OPEC” in determining global prices.

If you can’t effectively discuss production agreements between OPEC on the one hand and thousands of American producers on the other, move on Russia. At least its state entities continue to control almost all production and exports.

In some sense, it looks like OPEC is trying to find a face-saving alternative, declare victory, and bring prices back to better levels.

Russia has been losing revenue as well in the low price environment. The Kremlin would also like to see OPEC end its dual policy of increasing production and lowering prices. But it is hardly going to cave in at this point. Previous OPEC overtures on common strategy with Russia have only intermittently bone fruit.

It’s not likely to be any easier this time around… even with both sides feeling the financial pain.

Source http://oilandenergyinvestor.com/2015/09/how-opecs-attempt-to-save-face-affects-the-oil-market/

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