Why Traders Are Wrong to Fear the OPEC-Russia Oil Deal

Why Traders Are Wrong to Fear the OPEC-Russia Oil Deal

by | published September 23rd, 2016

For the last few days, energy markets have focused on nothing but next week’s International Energy Forum (EIF) in Algiers.

The latest news broke this morning, with reports that Saudi Arabia has offered to cut oil production in return for Iran agreeing to freeze theirs.

Traders, however, seem to be brushing the possibility of a deal aside.

This lack of reaction is partly due to the 5.2% run-up in U.S. oil prices over the last two days. A pull-back is to be expected.

But another reason is that traders have finally begun to think about what exactly a deal on oil production would really mean.

Unfortunately, they’re getting it all wrong.

And a statement by Russia’s Finance Minister isn’t helping…

Suddenly, Higher Oil Prices are Bad News

This morning, Russian Finance Minister Anton Siluanov stated the obvious but unspoken truth behind the recent oil deal discussions: an agreement could lead to a short-term rise in oil prices.

And now traders are concerned that a rise in prices would encourage additional production, especially from U.S. shale producers, being added back into the market, which could temper any long-term gains in price.

While that’s true, it’s important to keep what the real focus of the IEF conversations in Algiers is about. Yes, any deal made between Saudi Arabia (and OPEC along with it) and Russia that boosts oil prices will entice new production. But that is simply the ongoing dynamic of a balance kicking in.

Prices should be set by actual supply and demand. Those, in turn, come from what the market tells us, not from export-dependent governments that use artificial production levels to put their thumbs on one side of the scale or the other.

Here’s the current oil market reality…

Oil’s Price Floor, Not Ceiling, is Key

A trading range is emerging that puts crude between $50 and $65 a barrel, although the ceiling here is not likely to appear until the second quarter of 2017. The floor, on the other hand, is going to be showing up much earlier.

And as you’ve seen me say before, while the ceiling of the price is what gets all the media attention, it’s actually the floor that is far more important. That is now showing clear signs of moving up.

For some time now, I’ve been forecasting an oil price in $50s by the end of this year, rising to the low $60s toward the end of the first quarter of 2017. That now seems to be where most objective analysts are pegging it.

I say “objective” because we still have a penchant for investment houses to run shorts and then attempt to convince everybody else the price will go down. These “Chicken Littles” from “The Sky is Falling Brokerage Agency,” as I like to call them, have a vested interest in low-balling their price projections.

Now, while any spike in oil price does entail the possibility of increased production, there are actually four reasons to doubt that’s going to happen here…

Here’s Why Higher Oil Prices Won’t Flood the Market

First, just because American companies have considerable excess reserves that they could flood into the market doesn’t mean that they will. Over the last few years, producers have learned that jerking the price around is not very conducive to a stable bottom line.

Second, the breakeven profitability point for the vast bulk of U.S. shale and tight oil production remains at about $65 a barrel. That means that while a rise in price may entice some of the more marginally profitable producers, most will remain in the ground.

Third, the ongoing debt crisis in high risk (i.e. “junk”) bonds used by the vast majority of U.S. operating companies continues. The end result is already clear. Bankruptcies and M&A have intensified. There will be fewer players in the market when the dust settles and a more financially secure rationale for maximizing asset value by balancing production.

Fourth, the demand picture continues to improve. Figures released by the International Energy Agency (IEA) have been significantly misinterpreted. While they have been portrayed as a cut in earlier estimates, they still leave us with the highest daily demand figures in history by the end of this year.

In addition, both the IEA and OPEC have more recently telegraphed that a revision upward in global demand may be needed. In less than three weeks, I will be at the IEA headquarters in Paris to discuss the estimates in greater detail. As always, I’ll bring you along.

Now, you have to assess any announcements from Algiers against all four of these. And any such assessment will depend on two key relationships…

These Two Relationships Will Determine Oil’s Future

First, between Saudi Arabia and Iran, and second, between OPEC and Russia.

Iranian officials have stated over the past week that they are in favor of steps to stabilize the global oil market. But they are also on record as saying that they will not cut their production until it has reached the 4.2 million barrels per day level the country recorded before Western sanctions were introduced.

Currently, Iran is producing something closer to 3.6 million barrels per day.

Saudi Arabia, meanwhile, is pumping about 10.2 million barrels a day. Saudi Aramco (the national oil company) has indicated the country could reach 12.5 million a day and sustain it for years. But doing so would require damaging reservoirs, impairing long-term prospects.

Russia is now pumping 11 million barrels a day in an increasingly desperate attempt to raise revenue from a low-priced export. Russian export grades also trade at a large discount to Brent, further depressing returns.

The competition over the past 22 months has resulted in oil producers wrestling for market share with each other. All of OPEC is now suffering from budget crises similar to the one in Moscow. Every producing country is now feeling the pain.

In my judgment, Algiers will produce the beginning of a consensus to bring production down to the levels seen at the beginning of 2016. That still was one of the highest in years. Iran will find a way to proclaim victory (reaching 4.2 million barrels a day or thereabouts in book production – some of which remains in situ oil not actually lifted), the Saudis and Russian will ease off the accelerator, and prices will begin a slow advance.

But this is not going to happen overnight. The resulting balance will still have traders looking over their shoulder at the largess of excess reserves. That will be the real “cap” emerging in oil markets.

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  1. ivo
    September 24th, 2016 at 02:28 | #1

    pls Mr Moor can you be more specific on:1° the floor” as the key point in nubers; 2° give us pls the example precise of discounts for say “ural” or some other oil
    ad 1° where is “floor” in real market or sqpeculative market or both and howyou calculate “balance”

  2. September 24th, 2016 at 05:12 | #2

    Wall Street must reducing reserve from FED,and working with low return!

  3. September 24th, 2016 at 17:00 | #3

    Whst about Nigeria and Yemen.

    I do not think they will be any cut production after Algeria discussion… what i see is Saudi will request more loan and the selling of part of Saudi ARAMCO to help them to reduce their deficit.

  4. Lorraine
    September 30th, 2016 at 12:27 | #4

    How many barrels a day here in America? Compared to other countries how much reserve? Is Conoco American? How are they doing?

  5. John Snyder
    October 27th, 2016 at 18:56 | #5

    I want to ask, Mr. Moors, can you say what octane rating the fuel that Russia is using? When Russia ‘ eases their foot off the gas’ will there be a big ‘ jerk’ in the markets, due to Russia easing?

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