All Eyes on OPEC

It was a year ago this week that OPEC met and made a decision that continues to roil the world’s oil markets. Some have called the oil exporters’ refusal to cut production the biggest mistake in the group’s history. It has been estimated that members subsequently lost some $500 billion in revenue, and OPEC’s policy continues to hurt oil producers worldwide as well as investors in oil companies.

To review, oil prices had been falling in the months leading up to OPEC’s November 2014 meeting, and the general consensus was that members would probably agree to cut production in order to balance markets and prop up the price of crude. Instead, they decided to defend market share. OPEC’s rationale was that cutting production would only help shale oil producers grow their market share by allowing them to maintain high margins. So OPEC decided to produce all out, and the drop in oil prices that began in the summer accelerated following that meeting.

Without a doubt OPEC — and more specifically Saudi Arabia, which maintains the biggest influence within the group with over 30% of the cartel’s production — miscalculated. At the time of the meeting, oil prices were still above $70/bbl. OPEC members likely envisioned that oil would drop another $10-$20/bbl as they started to put more crude on the market, and that this would promptly put an end to the U.S. shale oil boom that had added 5 million bpd of new crude capacity over the past five years.

Their decision at the time was defensible, but it was risky. The oil markets were already showing signs of being oversupplied, and crude had already fallen by $30/bbl since summer. What if their move failed to adequately shut in enough shale oil production and instead extended the oil price decline?

In fact, that’s exactly what happened. Oil prices swiftly moved lower and found a floor around $40/bbl. The price would make a move back to $60/bbl, but each time crude has tried to make a run this year it has returned to that floor. So the price impact was much worse than OPEC anticipated.

But worse for OPEC was that shale oil producers became much more efficient. They focused on the sweet spots in the shale plays. They optimized the number of stages and the amount of sand used in horizontal wells. They deeply cut expenses. So, even though most of them continue to operate in the red, they aren’t nearly as deep in the red as one might expect given this year’s average oil price. That means all but the weakest have been able to survive OPEC’s price war. Production has begun to decline, but in order to make a serious dent in U.S. production OPEC might need to absorb another $500 billion hit. But will they?

That’s the big question as OPEC again prepares to meet on Dec. 4. They are now a year into this price war, and many OPEC members have been vocal about making necessary moves to push prices back up to $70/bbl or higher. But Saudi Arabia — the driving force behind this strategy — knows that it will be heavily criticized if the group changes course now. After all, what did their $500 billion blunder gain them? Not much. U.S. shale production has declined modestly, and while it will continue to fall with oil under $50/bbl, any recovery in oil prices is likely to arrest that decline.

I predicted in January that the price of West Texas Intermediate (WTI) would not close this year below $40/bbl. While we did see it briefly below that point, $40 has proven to be a pretty sound floor this year. But crude inventories continue to grow, and the markets will be closely watching the OPEC meeting for guidance of where we go from here. Unless OPEC announces cuts to production quotas — which at this stage would be admitting its strategy hasn’t worked — crude may slip below that $40 floor.

I am keeping a bit of powder dry just in case. Join us at The Energy Strategist to see which stocks are at the top of my year-end shopping list.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)



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