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The Truth About Oil’s “Big Freeze”

by | published February 17th, 2016

With word swirling about Russia and Saudi Arabia agreeing to freeze oil production, the talking heads are up in arms about whether it will make any difference or not.

As usual, the devil will be in the details.

On the table is an accord to keep production at January levels, with most of OPEC probably following Saudi Arabia’s lead.

In the short term, getting Iran onboard is key. Today, meetings took place with Russia, Saudi Arabia, Qatar, and Venezuela on one side of the table, and Iran on the other.

The official goal was to get Iran on board with the production freeze.

But my contacts are telling me a different story…

Oil’s Big Freeze Caused Market Euphoria

The market euphoria that followed the initial announcement of the oil production freeze prompted prices for the benchmark West Texas Intermediate (WTI) crude to rise over 12% on Friday.

However, after the long holiday weekend and some reconsideration, prices declined yesterday.

Today, the level is moving up again with both WTI and London Dated Brent (the other primary global benchmarks) trading at higher levels than we’ve seen in weeks, especially in light of positive comments from Iran on the new oil production freeze.

Now Iran, which at least in the short term will be key to any further deal on oil production, has as its immediate objective the attainment of the production (and export) levels it had prior the sanctions.

Yet, as you’ve seen before here in Oil & Energy Investor, the declining condition of Iranian fields and infrastructure will make it difficult for the NIOC to remain at pre-sanction levels. Iran’s full return to the international market will take longer than anybody in Tehran wants to admit publicly.

What’s more, my contacts at the National Iranian Oil Co. (NIOC) express considerable frustration over Iran’s official stance…

Internal Conflicts Make for Bad Iranian Policy

You see, conflicts over how to approach coordinating oil production with the outside world continue within Iran.

On one side we have Iranian government and oil ministry officials, who see an opportunity to carve out a legitimate position for the country’s exports after years of Iran laboring under Western sanctions.

On the other side, we have influential conservative Iranian clerics who continue pushing a hard line against any foreign pressure and influence.

Now, everybody in Iran would certainly like revenue from oil exports to begin flowing again after the sanctions have been lifted. The country’s domestic economy is in shambles, its currency (the rial) has little effective market value beyond barter, effective unemployment is far higher than the government’s figures indicate, and the availability of basic foodstuffs has been erratic for years.

But in the case of oil – like most other matters in Iranian life – efficiency takes a back seat to ideology…

Iran’s Ayatollahs Are in Charge

Unlike in many Sunni countries, Iran’s ayatollahs have a disproportionate say in the way Shiite Iran makes decisions. Clerical councils have the ability to nullify government actions and even limit certain moves altogether, given the clergy’s oversight responsibility on religious matters.

That has made it difficult, for example, to revise Iran’s widely disliked buy-back contract method of bringing foreign companies into field projects inside the country. It also prevents Iran from establishing more efficient ways of exporting crude oil and natural gas.

According to the 1979 Constitution and the laws based upon it, foreign entities are not allowed to own either Iranian land or raw materials. That makes standard joint ventures (in which companies own and book a percentage of the oil reserves) illegal.

What’s left has been a cumbersome and widely disliked system where the outside company fronts all the expenses, turns over a field to the NIOC, and is paid in oil according to a pre-agreed figure.

Recently, the NIOC has announced a new contract approach that was supposed to be unveiled at a meeting in London. Unfortunately, the infighting back home has prompted that meeting to be postponed three times.

I am scheduled to be there in a few weeks and will let you know what (if anything) ultimately happens.

Which brings us back to the issue of the oil production freeze, and the attempt to get Iran on board with it. Contacts are now telling me that’s not quite what was happening…

Sources Say OPEC Will Allow Iran to Increase Exports

My sources are saying that Saudi Arabia and other OPEC members (including Kuwait and the United Arab Emirates) are prepared to allow Iran some leverage in ramping up its oil exports.

While this may not go down well with everyone, it may well be the only way any deal on oil production can be made to last. For some time now, OPEC has been shooting itself in the foot – moving to maintain market share while at the same time overproducing in a desperate attempt to generate revenue.

Now, the proposed production freeze, even with an exception for Iran, does not immediately change anything in the aggregate. Overproduction is still occurring and the market is receiving about 600,000 excess barrels a day with storage availability beginning to be a factor.

In the world of supply and demand, therefore, a freeze should not have much impact on pricing now.

But there’s more to the markets than just supply and demand…

Global Oil Demand Will Increase Faster than Expected

Much of the pricing of crude oil in this market is psychologically driven. So, even if initially there is no accord on cutting production, putting a cap on oil output will shore up prices.

Especially with Iran on board.

And there’s an additional element to consider…

The longer a production freeze remains in force, the greater the likelihood that there will be a more noticeable impact on prices. That’s because moving into the second quarter of this year, global demand will be rising.

And unofficially, the picture is even better. Privately, OPEC is now showing in its analysis that global demand will be coming in higher than the cartel initially forecast, setting oil prices up for a rise even sooner.

So this deal is far from just a wasted effort.

Now, this is not going to bring back $70 a barrel oil (or even $60).  But that is not necessary. I see crude at the mid-$40s by the end of the second quarter.

At that price, there will be several options available to make some nice money.

P.S. With oil prices rising sooner than expected, and with Iran’s new oil contract revealed soon, you’re going to have some nice opportunities to profit. Stay tuned.

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  1. Allen Novotny
    February 18th, 2016 at 12:22 | #1

    It seems to me that companies like frontline(FRO) would be soaring since they have so many tankers with storage capacity that should make them a ton of money. Yet it’s floundering. Go figure.

    Allen

  2. Blain
    February 18th, 2016 at 21:46 | #2

    Let’s hope that the boys with the power make the right move and not out too much pressure on those who could potentially cause a global uprising.

  3. MAGALY SCHMID
    February 18th, 2016 at 21:57 | #3

    I will follow your recommendations since you are the expert.

  4. kkflash
    February 19th, 2016 at 07:41 | #4

    On the water tankers are the last resort in oil storage because of the high cost. Frontline and other tanker companies will benefit from the glut though, when other options are full, and again when rising demand requires all that stored oil to be moved from where it is to where it’s needed. I’m a buyer of beaten down tanker companies at these levels.

  5. Imran
    February 21st, 2016 at 14:30 | #5

    I am guessing oil below 40 by the end of second quarter. It is going close to 50 by the year end but not going to 70 again in the next five years. Otherwise it is the same mistake what the suadies make before. Suadies main mission is to keep pricesses low to that level where small players go out of business. There is no future for any small companies in the oil patch in North America.

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