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Saudi Arabia’s Success is About to Kill OPEC

by | published May 31st, 2016

There is a Saudi proverb that says: “A cloud is a promise, rain is fulfillment.” Well, as far as the oil market is concerned, it is raining cats and dogs (or maybe camels). That’s because the Saudi oil strategy appears to be working.

However, that strategy may well kill OPEC in the process.

On Thursday, June 2, ministers and OPEC “governors” (ambassadors) assemble in Vienna (the site of the OPEC Secretariat) for the cartel’s next meeting.

What we may actually witness is a clear signal of OPEC’s declining influence.

Here’s what’s going to happen in Vienna… and how that will change the Arab world, and global markets with it…

OPEC Will Hold the Line in Vienna

What will ensue in Vienna is yet another holding of a line created back in November of 2014. Then, at the insistence of dominant member Saudi Arabia, OPEC broke with tradition and maintained production levels, rather than cutting them, in the face of a rising global surplus. What followed was a dive in crude oil prices.

That line these days is wearing thin. Despite significant increases in production by OPEC members and Russia – well beyond the levels necessary to meet demand – there is a balance forming in the international market.

That balance, in turn, is rapidly setting a higher floor for crude sales, while the ceiling is likely to remain at about $50 a barrel for a while.

OPEC members have been producing at an aggregate of over 34 million barrels a day for all of 2014. While this overproduction has been getting much press, the total actually encompasses only about 2.5% above what it amounted to in November of 2014. Additional volume has come from Russia, more recently from Iran and Iraq, and also from unconventional (shale and tight) oil lifting in the U.S.

Russia and (of course) the U.S. are not members of OPEC. Iran and Iraq are, but neither has had a monthly quota from the cartel for some time. That means any additional production from these two countries that is exported will come at the expense of current exports from other OPEC members.

Here’s the bottom line on the supply side…

No One Can Afford to Keep Oil in the Ground

OPEC and other producers are now actively competing for the same primary end users, a battle that is now increasingly moving to the Asian market. This movement will intensify and comprise the main expansion of crude oil demand through 2035.

The global market will be driven by Asian needs.

Against this backdrop, OPEC members opened the proverbial can of worms by moving from defending price (by cutting production levels) to defending market share (by maintaining, or even increasing, production).

For its part, Saudi Arabia has moved to increase its own production. This was both an attempt to continue leading the “market share defense” approach and a less-than-convincing cover up for the fact that other OPEC members were wildly selling above their monthly quotas anyway in a desperate attempt to gain revenues at any price.

In other words, the effective suspension of OPEC-member monthly quotas effectively telegraphed the increasing desperation.

All of this results in an environment whereby no producer can afford to keep oil in the ground. By limiting supply, this had been the traditional means of raising prices.

But today, doing so simply sacrifices potential sales to some other producer. The price doesn’t change, but the nation that decides not to pump does lose market share to somebody else.

What OPEC now needs is a way for its members to avoid a fatal race to the bottom…

The “Oil Freeze” is Off the Table

But don’t expect an “oil freeze” – there will be no accord among the main oil nations to cap production anytime soon. The expectations leading into the Doha meeting just about one month ago have been crushed.

Then, a scheduled follow-up meeting in Moscow between OPEC and a list of non-cartel producers headed by Russia was scrapped. And Russia, which usually sports a large “observer’s” contingent at OPEC meetings, will not even attend OPEC’s June 2 session in Vienna.

On the other hand, there are indications that the overall policy is beginning to show some results. Despite renewed Iranian production, most OPEC analysts are now saying the Saudi market share approach has started to push more expensive producers out of the global market.

Nonetheless, despite prices stabilizing even in the face of a short-term increase in Russian production and the prospects (thanks to new tax benefits from London and Oslo) of a slowing down of the North Sea’s production decline, oil prices remain well below what OPEC countries require.

The net impact of low oil prices will be playing out in much broader ways in the MENA (Middle East North African) region, and will affect all of us…

The Second Arab Spring is Coming

Lower revenues from oil sales will be translating into cuts in social programs and a rise in taxes back home. That means MENA nations will no longer be able to buy off the opposition with more domestic spending and subsidies. There are simply no oil funds to do it.

As Arab Spring II approaches, that’s the first of two new elements not present in the initial round of protests that shook the region some five years ago. The other will be a sectarian Sunni-Shiite conflict finding its way into the center.

More unrest in the MENA region, especially in the (previously) more stable countries, will have wide-ranging knock-on effects on global markets.

Meanwhile, Saudi Arabia is intent on keeping its market share as high as possible to support the value of its producing behemoth Saudi Aramco in advance of its privatization. True, the initial move is to sell only 5%. But that small percentage is likely to generate an investment fund of $2 trillion – by far the world’s largest.

Riyadh will continue to pay lip service to the importance of OPEC. Yet its interests are now clearly in the post-oil export era. Oil will still play a major role in Saudi policy.

But that role will be as the foundation for a worldwide financial push aimed primarily to do with acquiring positions in many other marker sectors – a move sure to affect many of us as well.

It may not quite be time to send flowers yet, but OPEC is in dire straits. And the main reason is that the cartel’s long-time leaders, Saudi Arabia, no longer consider OPEC to be important.

Controlling 40% of the world’s oil supply just doesn’t buy what it used to.

Together, the Saudi privatization of Aramco and Arab Spring II (or should be) bringing the MENA region back into the investment spotlight. Rest assured that we’ll be covering this situation over the next several months right here in Oil & Energy Investor.

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  1. George Kunnath
    June 1st, 2016 at 11:05 | #1

    If producers / sellers of a commodity come together and artificially raise the price by hoarding ( above the ground or below the ground) and creat artificial scarcity of that commodity then such group of producers/ sellers are called “CARTEL” in mild terms and ” BLACK MARKETEERS” in plain words. OPEC is one such group of Black marketeers. If OPEC dooms , it is good for the rest of the world, particularly to third world.

  2. conrad stauffer
    June 1st, 2016 at 13:00 | #2

    please expound upon the “best” strategy to cash in on the “imminent” privatization, or spin-off of Saudi Aramco’s 5%.
    1) how can we have an accurate heads-up as to when this will occur? (if indeed it does)
    2) would buying stocks outright be better than options? ( buy calls? puts?)
    3) how best to “play” the hysteria that is bound to ensue with the initial public offering?
    It seems to me that entering into that fray would be very risky, and best approached with the cerebral brinksmanship of a master chess player…. so I turn to you.

  3. Charles Roller
    June 3rd, 2016 at 17:23 | #3

    Do you really think that Saudi Aramco is really worth 40 Trillion dollars? (2 Trillion at 5%). It strikes me as odd that the investment world would be willing to buy an asset like that. It’s not like buying the London Bridge — which is big but still moveable. Saudi Aramco is:

    1) In Saudi Arabia. What’s to prevent the Saudi’s from freezing, seizing the oil and infrastructure.
    2) Assumes that Saudi Arabia is a stable, nice nation — It is not.
    3) If Saudi Arabia goes wobbly – who will defend or protect this 40T asset?

    The justification for this crazy transaction assumes that the status quo will be maintained, both politically and financially, as the Saudi oilfields are sold off. Not sure it will unfold like that.

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