What a difference a few days can make for oil.
Coming into this week, oil was drifting down, on doubts about the rumored OPEC oil deal. Then, on Wednesday, several OPEC oil ministers announced that they’d agreed to cap production.
Almost instantly, U.S. oil prices shot up 6%.
But come Thursday, the enthusiasm had waned, as traders really looked into OPEC’s oil deal… and didn’t like what they saw.
Now, as with any supposed deal between countries that are at each other’s throats, the devil will be in the details. That’s certainly the case here.
But analysts saying OPEC’s announcement was a complete failure are wide off the mark.
So today, I’m going to walk you through the details of this plan…
An Oil Deal Will Help Balance the Market
As I noted in my CNBC interview from Algeria earlier this week, OPEC had to move on oil production or face an increasingly accelerating financial mess. Wednesday’s announcement brought welcome relief to the oil market, with prices spiking more than for any trading close since February 12.
Of course, back then, WTI spiked from a low of $26.21 a barrel. As it turned out, February 12 marked the low ebb of the oil pricing cycle in one of the worst downturns in memory. As of close Wednesday, WTI has risen 80% from that low.
But the challenge to analysts has always been determining what would create a lasting jump in oil prices. The global market continues to face a glut of oil, as well as large amounts of reserves that are easily extractable, should prices make it worthwhile.
That prices have been rising anyway shows that a balance is in sight. Now, this balance doesn’t mean that there’s only enough oil on the market to meet short-term demand.
As I’ve explained here in Oil & Energy Investor before, that kind of “just-in-time” approach to supplying oil would guarantee very unstable prices.
Instead, this balance involves matching expected supply with demand, with a cushion to cover any emergencies.
And that’s where OPEC’s announcement comes in…
OPEC’s First Step: Announce a Production Cap
As I mentioned in the CNBC interview, there was no chance for OPEC to lay out anything but a general statement of intent before delegates left the International Energy Forum (IEF) ministerial meetings in Algiers.
Now, here’s what that “sketch” of a plan looks like: OPEC has agreed to put monthly cartel aggregate production at between 32.5 million and 33 million barrels a day. This is in line with the cartel’s monthly output for January, and was previously used as the cap during the failed Doha meetings.
(If that sounds familiar, it’s because I called OPEC settling on the January production figures last week.)
This also puts overall OPEC production at a level that cannot be sustained over any moderate period of time without significantly damaging reservoirs, along with future revenue flow, in many producing countries.
Of course, production has actually increased since January, as nations both inside and outside the oil cartel wrestled for market share in a destructive zero-sum game that ended up keeping prices down for everyone. That just made things worse for countries that depend on oil sales for their finances – including all of OPEC.
So using January’s production figures just redresses the basic production-side situation and provides a readily available cap. In other words – despite what some talking heads may be saying – this is not a production cut, but just a targeted upward limit.
But announcing a goal like that was the easy part. What comes next will be much harder…
OPEC’s Second Step: Divide The Cap Between Member Countries
First, OPEC will now have to decide which member countries get to produce how much under this limit, by assigning monthly quotas.
Every month, the cartel determines expected global oil demand and deducts the forecasted supply from worldwide non-OPEC production. What’s left is the so-called “call on OPEC” – the amount of oil the market needs OPEC to supply.
This “call” is then divided among cartel members through the monthly quota system.
But reintroducing these quotas will be a problem, because of Iran and Iraq. While both are members of OPEC, neither has had a monthly quota for years. And yet capping production without their involvement will be impossible.
Now, when it comes to Iran, things look better than last time. When OPEC last discussed a production cap, in April in Doha, Iran didn’t even attend the meeting.
So when Saudi Arabia insisted that Iran agree to any deal, the production cap was dead in the water.
This time around, however, the Iranians did attend.
But another important party didn’t…
OPEC’s Third Step: Get Russia On Board
You see, regardless of what OPEC agrees to internally, any production cap will be unsustainable without the agreement of major non-OPEC producers – a group led by Russia.
Getting them on board will be OPEC’s second step.
Now, Russia is currently producing an estimated 11.5 million barrels a day, a level that is unsustainable.
Russia is moving production up-front from a basin system that is already in marked decline. Pumping out whatever they can get from mature fields is reducing pressure to an alarming level. That guarantees a steeper decline in extractable reserves than would otherwise be seen.
So it was understandable that Moscow was indicating support for a cap both at Doha and Algiers. That would let the Kremlin ease off the throttle, and reduce oil production to more sustainable levels.
But at the moment, the problem is that Russia has yet to chime in on OPEC’s oil cap plan. If the Kremlin decides to provide lip service to the oil deal, but continue competing for market share behind its back, OPEC’s attempt to limit oil production will fail.
So expect to see intense negotiations between OPEC and Russia.
But that still leaves out another major oil producer…
OPEC’s Fourth Step: Hope U.S. Producers Don’t Ruin the Deal
The bulk of the world’s extractable, unconventional (shale and tight) oil reserves are right here in the U.S. That makes America’s impact on any oil deal crucial.
But unlike the other major producers, the U.S. has no national oil company or centrally controlled national oil production policy. That means U.S. producers cannot sit at a table in Algiers and commit a national position to any agreement.
At the moment, the U.S. impact on global prices is still largely a result of crude import levels. While American extractors are now allowed to export oil, it will take some time before that has a tangible effect.
OPEC will have to hope that its production cap doesn’t raise prices enough to make it possible for U.S. shale producers to flood the market…
Where OPEC Goes from Here
So as you can see, the agreement from Algiers is still a threadbare framework with little substance. A considerable amount of negotiations must now take place inside the cartel, where the ongoing animosity between Saudi Arabia and Iran must be addressed on a much broader level than simply oil prices.
And then there is the necessity to bring outside producers like Russia on board while trying to predict what increasing production levels in the U.S. (a probable given the expected rise in market price) may mean to the cap.
Until the deal is finalized, pundits will express guarded optimism. Mind you, we’ll still see bouts of volatility. Remember, the key here is to raise the expected floor of oil’s price range, not focus on the ceiling.
And when it comes to securing and raising that floor, OPEC’s eventual deal will be highly effective – if successful…
Now, the complete OPEC formula is supposed to be announced at the cartel’s next scheduled meeting at its headquarters in Vienna. That takes place on November 30. But the reality requires one or more meetings be held both inside and outside OPEC before them.
As a result, I still predict that at least one extraordinary meeting will be held within the next four to six weeks to include OPEC, Russia, and perhaps other producers.
I’ll keep you posted, right here in Oil & Energy Investor.
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