Here’s Who’s in Charge of the Oil Deal Now (It’s Not OPEC)

Crude oil prices moved above $52 a barrel for WTI (West Texas Intermediate, the oil benchmark rate traded in New York) before the market even opened yesterday, while Brent (the equivalent rate set in London) was above $55.

Of course, the price surge results from last week’s “Vienna Accord” – the deal to cut oil production reached by OPEC during its regular meeting in the Austrian capital.

The point of the deal is to quicken the arrival of a balance between oil supply and demand. That, in turn, enables the medium-term objective: lowering expected price volatility, essential to maintaining a higher oil price.

But none of this is possible if the Vienna Accord itself doesn’t last.

On that front, things aren’t looking too good. Russia has to get formally on board, and individual OPEC members need to be assigned their quotas. But that’s just the beginning…

The real factors determining whether the deal will survive aren’t even in OPEC’s hands.

They’re much closer to home…

OPEC’s Quotas Will Be Key

As regular readers of Oil & Energy Investor will recognize, the prices for WTI and Brent are where I estimated they would be by the end of this year – mid $50s.

This morning the oil price is under pressure as both OPEC and Russia predictably increase production before the accord takes hold in January – making the setting of individual quotas quite tricky.

Those quotas are the source of a lot of discord within OPEC, as they will require most member countries to cut, while Iran and Nigeria were allowed to simply cap their production.

Even Iraq’s acceptance of the cuts is wavering. Similarly, while committing to at least half of the production declines required from non-OPEC countries, Russia is still viewing the Vienna Accord with suspicion.

All the main parties need to hold the line on production volume, or the whole accord collapses. Unfortunately, as I have observed before in Oil & Energy Investor, these days there is no justification for individual countries to keep oil in the ground. Doing so just means giving up market share – and revenue – to some other country willing to grab it.

I predict that the January production level of 32.5 million barrels a day will be obtained by OPEC (although with some expected over-production from the likes of Venezuela, Libya, Iraq, and Iran pushing the total closer to 33.2 million), with non-OPEC production roughly holding to expectations.

That’s in the first quarter of 2017.

The more serious concerns about the sustainability of the Vienna Accord will kick in by the beginning of the second quarter…

The Vienna Deal is Changing How Traders Price Oil

There are two overriding factors when we reach that point. One deals with how traders approach the Vienna Accord. The second is what U.S. oil production will add to the mix.

We’ve talked about each of these in Oil & Energy Investor before, but both have taken on added urgency now that the Vienna push has unfolded.

You see, it’s been some time since the actual price of oil for delivery has driven the market price. Its futures contracts that do that, and the spread between such “paper barrels” and the actual underlying consignments of crude in trade (the “wet barrels”) determine the volatility.

This is where the expected volatility I mentioned above comes into play.

A real pricing range is determined not by the “ceiling” (the highest price in the range), but by the “floor” (the lowest price in the range). And that floor is set by traders and materializes in the arbitrage between paper and wet barrels as futures contracts expire.

What I call expected volatility determines where contracts are pegged and parallels the so-called implied volatility calculated when option prices are determined.

In normal markets, the relationship between the futures contracts (controlling the delivery of oil to occur later) and the options set to hedge those contracts determines the net exposure of the trader. Essentially, the contract price is set at the expected cost of the next available barrel.

However, in market conditions where the price is moving decidedly in one direction or the other, a trader’s approach is different. Then, the price becomes the expected cost of the most expensive next available barrel (when prices are rising) or least expensive next available barrel (when prices are falling) – reflecting the direction in which the trader has to position primary hedge moves.

Reductions in expected volatility point toward both a balancing of the market and gravitation to narrower spreads. This becomes the foundation of trading stability.

But it requires an anticipated monthly level of oil coming to market.

And that requires some confidence among the paper barrel-wet barrel players that a move such as the Vienna Accord will hold…

U.S. Shale is in the Driving Seat Now

Second, the wild card of U.S. production has acted like the 600-pound gorilla in the room ever since Doha in April. Back then, an attempt by OPEC to set a production cap failed.

That was followed by an initial “breakthrough” coming from marginal meetings at the International Energy Forum in Algiers at the end of September, and led to Vienna last week. In between there were several meetings both on and off the radar.

At none of these gatherings was American production represented. Given decentralized oil production and the lack of a national oil company, there was never a way to represent the U.S. at a table expecting any agreement to translate directly into U.S. policy.

Nonetheless, from the outset of the Saudi-inspired decision in November 2014 to defend OPEC market share instead of oil prices, U.S. producers have been the outlier. Technically, they impact global prices only through the levels of imports into the U.S. While Congress has finally allowed American producers to export crude out of the country, that is not likely to have an impact for some time.

Nonetheless, the reaction of U.S. producers to the Vienna Accord will have an effect on setting global prices.

Some additional drilling is expected. Nonetheless, with oil trading in the low $50s per barrel, most of the U.S. shale patch is still unprofitable. Improvements in field operations and efficiency have lowered well-head operating expenses by about 17% nationwide. Still, profitability for most operations requires a higher price.

On the other hand, if we do reach my projected price estimates of low $60s per barrel by the end of the first quarter 2017, we will have another situation kicking in that. The Vienna Accord will have to hold in an environment likely to restrain further price advances in the absence of: (1) a firm market balance; and (2) accelerating global demand.

In other words, the two major factors determining whether the production accord is sustainable were not “sitting at the table” in Vienna. Even more interesting, they are not under the control of OPEC.

Instead, everyone is looking at U.S. shale oil producers now.

And that means 2017 is going to be a great year for energy investors…

The post Here’s Who’s in Charge of the Oil Deal Now (It’s Not OPEC) appeared first on Oil & Energy Investor by Dr. Kent Moors.

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