OPEC Scrambling as Oil Fundamentals Remain Bearish

OPEC Scrambling as Oil Fundamentals Remain Bearish explained by professional Forex trading experts the “ForexSQ” FX trading team.

OPEC Scrambling as Oil Fundamentals Remain Bearish

The eyes of the world have been on the price of crude oil since the energy commodity began its descent into the abyss. Crude oil was trading at over $107 per barrel in June 2014. At the end of March 2016, the price was around $34 after trading down to lows of $26.05 in February. By late March the price was at the $40 level – an increase of over 50% from the lows just six weeks earlier. Crude oil is one of the most important and liquidly traded commodities in the world.

The price of oil affects almost every asset class. Crude oil closed the first quarter of 2016 at $38.34 per barrel on the active month NYMEX futures contract.

Why Is Crude Oil Important?

Crude oil is an important indicator of the health and well-being of the global economy. Growth leads to more economic activity, which increases demand for energy. Equity prices are highly sensitive to the price of crude oil. The reason is two-fold. When the price of oil drops, companies that require the commodity for manufacturing and operating purposes see their cost of goods sold drop. This tends to allow them to decrease prices and increase volume. In some cases, if prices remain stable for goods, it means that profit margins rise due to lower energy expenses. The other reason that crude oil is important to equity prices is that so many companies involved in the exploration for and production of oil trade on equity markets.

Additionally, the oil price directly impacts the share prices of companies involved in oil services, refining, and other related industries.

Crude oil influences currency values as well. Consuming nations benefit from a lower oil price as it stimulates the economy. For producing nations who depend on the price of oil for revenue flows, a lower crude oil price decreases cash flow thus resulting in a weakening of their currency.

Other commodity prices reflect energy prices as oil is often a key cost of goods component in raw material production. Thus a higher oil price increases production cost and a falling oil price will lower the bar for total output costs.

A Cartel With Changing Dynamics

OPEC, the oil cartel, is an important body when it comes to world oil production. When prices are high, the cartel operates on autopilot. When they fall, the cartel tends to scramble. That is because the thirteen member nations all have differing interests and motivations. The dominant members of the cartel are the lowest cost producers. Nations like Saudi Arabia, Iran, and the Gulf States produce oil at a lower cost than many of the other members. Therefore, when prices fall countries like Venezuela, Nigeria, Angola, Algeria and Ecuador often find themselves in serious economic straits. The weaker countries have looked to the stronger nations for production cuts during periods of price weakness and often the stronger producers have resisted. That was the case in March 2015 as the oil price languished at the lowest level in years.

Additionally, two of the biggest oil producers in the world are Russia and the United States.

Both of these countries are not members of the cartel. In February 2016, at a meeting between the Russians and Saudi Arabia a “freeze” in production was discussed in response to the low price level of oil. Russia, a close ally of Iran, has a stake in the price of oil as they are the second largest producer in the world. Additionally, Russia and Iran have close ties due to aligned political interests in Syria and the Middle East.

Iran and Saudi Arabia have a difficult relationship. The two nations are engaged in a proxy war in Yemen. Additionally, they cut diplomatic ties early in 2016 due to the strains between the Shiite and Sunni Muslim world in the Middle East. At the meeting in February, Russia acted as a ‘front man’ for the Iranians in some senses. Two other nations present at that meeting were Venezuela and Qatar.

Venezuela represented the interest of the poor members of the cartel while Qatar has always taken the role of mediator between the Saudis and Iranians. The concept of a production “freeze” could be the first step on the road to a production cut for oil in an attempt to provide some degree of support to the price of the energy commodity. Meanwhile, the Saudi oil minister repeatedly stated that he did not favor a production cut. His reasoning is that member nations will cheat and produce more oil even if terms of an output cut are agreed by member nations. Whether the Saudis were positioning for terms or are steadfast in their opinion, the price of oil is highly sensitive to rumors of a cut in production. The lower the price goes the more sensitive it is likely to become.

Since the price of oil began to slump in late 2014 and 2015, the stronger members of OPEC lobbied the rest of the cartel to continue production and even increase daily sales. The unofficial OPEC output ceiling rose from 30 million barrels per day to over 32 million. Additionally, the nuclear non-proliferation agreement reached between Iran and Western nations resulted in an increase in Iranian production as the price of oil continued to fall. As a result, supplies kept rising in a market where price was falling. The theory behind continued OPEC production was that marginal high-cost production would slow when the price fell below production cost thus increasing market share for the cartel members. This did not occur and the price continued to fall.

At the beginning of April 2016, the fundamentals for the oil market remain weak. Production continues to rise and inventories have climbed to the highest level in many years. With an oil price at less than half the level it was trading at less than two years before, many oil producing nations have found themselves forced to increase production in order to receive as much revenue as possible from those sales. While the supply and demand fundamentals for oil remain bearish for price, the cartel could influence price if they were to cut production.

A Change In OPEC Policy Could Help Price

In March, an announcement from the oil producing nations surprised many in the market. A special meeting was called for April 17 in Doha in Qatar. Most of the OPEC member nations will attend, only Libya has said that they are not coming. The Russians will also be in attendance at the get-together. While not officially a meeting of the cartel, it is likely that the meeting was called as a next-step to the meeting that took place in February where the concept of a production freeze was discussed. The Russians likely influenced Iran to come to Doha. It is also a possibility that the Saudi stance on pumping as much crude as possible to build market share is changing.

The Saudis have been evaluating the potential to raise money by a sale of the portion of the Kingdom’s crown jewel, Saudi Aramco. Aramco is the world’s largest oil producing and refining company and an initial public offering or IPO of Aramco would likely garner a tremendous amount of investor interest from all corners of the earth. The Saudis terminated a long-standing refining joint venture agreement with Shell Oil in March 2016. This could have been the first step on the road to an IPO of their state oil company. The success of the IPO will depend on the valuation of the company. The higher the price of oil, the more Aramco will be worth to investors. Aramco is a low-cost oil producer; therefore it is in the best interests of the Saudis for oil to be as high as possible when the IPO takes place. This could lead to some fruitful results at the meeting in Doha.

More than half the world’s proven and probable reserves of crude oil are located in the Middle East. Politically, this is one of the most turbulent regions of the world. OPEC policy, stability in the Middle East and production from Russia and the U.S. is a complicated economic and political formula that will ultimately determine the price path of crude oil. The lower it goes, the more the cartel will scramble. Eventually, if oil reaches a price where the economic pressure intensifies on cartel members, they may be forced to cut production. However, so far oil has not reached that low price. The meeting in Doha on April 17, 2016, could prove to be a watershed event as the Saudis, the dominant member of the cartel, now have an interest in seeing the price higher even if it moves to the $50-$60 per barrel level for long enough for them to sell part of their state-owned oil company.