This article was published by The McAlvany Intelligence Advisor on Monday, October 31, 2016:
It is said that, in a game of chicken, the one who flinches first loses. Last week Saudi Arabia flinched.
It went to the global bond market, hat in hand, hoping to raise $10 billion to slow down its liquidation of its foreign reserves. Last year those reserves dropped by $100 billion. With the market stronger than anticipated (or perhaps because they knew it was the most they could raise for quite a while) they raised $18 billion.
That $18 billion will be gone in two months, leaving investors holding a piece of paper that might not be redeemable for face value at maturity. What will be left is the increasingly irrelevant cartel that Saudi Arabia has led for the last 55 years.
For proof, one need only look at the informal meeting the cartel's 14 oil ministers held in Vienna over the weekend. It was reported that they spent 12 hours hashing and thrashing, trying to find a way to an agreement (promised last month) that they could present to the formal OPEC meeting in November. Their efforts birthed nothing.
A cartel lasts until its members discover that their own self interests are better served going it alone. Iran was given special dispensation as it demanded the freedom to increase its production back to pre-sanction levels, and Iraq demanded equal treatment: after all, it has a war to fight and needs the money. Others complained about OPEC's estimated levels of production against which any agreement would be based. The meeting was, in a word, a mess.
Venezuela's Marxist president Nicolas Maduro left his country – some say to avoid the increasing difficulties at home – to present his case to the ministers in person: despite his country's enormous reserves, his socialist policies and political graft are turning his country back to third world status. He desperately needs higher prices. It's almost a question of survival, and he knows how former South American dictators are treated when the natives get restless.
There are other problems facing OPEC that are increasingly threatening to end its existence. The energy industry in the United States is restarting some of its idled rigs, while others are announcing increases in capex for 2017. A new challenge just came to light last week: American oil producers are completing the 5,576 DUCs – developed but uncompleted wells – that they put on the shelf waiting for the right time. Consider these wells as additional inventory. At present, according to the EIA, there are 500 million barrels of oil being stored underground and in tanks and tankers. The additional “inventory” represented by those DUCs is providing additional pressure on crude prices.
Because those DUCs require only to be completed, the marginal costs of bringing them on line are way below the current price of crude. The sunk costs are behind them, so the wells are profitable with break-even points way below $50 a barrel. The math is persuasive – so persuasive in fact that some observers expect all DUCs to be completed and operating by the second quarter of next year.
In addition, there are demands by banks to require oil producers to hedge their bets in the futures market as part of lending agreements. These demands, along with perceptions of merchants and investors, have resulted in massive shorts against West Texas Intermediate. On October 11, according to the EIA, there were 540,000 short contracts on WTI – the highest level since 2007.
It's a game of chicken that the OPEC cartel instigated and now finds that it cannot win and cannot quit. The cartel is discovering that it is itself becoming increasingly irrelevant, all thanks to a free market in the United States that the federal government hasn't been able to restrain.
Sources:
Wall Street Journal: OPEC Fails to Finalize Proposal to Implement Production Cut
Wall Street Journal: OPEC Deadlocks Over Iran, Iraq Oil Production
OilPrice.com: OPEC And The Upcoming Oil Crash: U.S. Producers Are Ready
ZeroHedge.com: The Bickering Begins: Iraq Disagrees With OPEC's Method Of Oil Production Estimates
OilPrice.com: Full Scale Oil Price Recovery Unlikely As 5000 DUC's May Come Online
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