This article was published by The McAlvany Intelligence Advisor on Monday, July 3, 2017:
Two weeks ago, the world price of crude oil officially entered a bear market, down more than 21 percent from its high early in the year. OPEC's plan appeared to be on track, taking enough production off the market to drive the price to $60 a barrel. That decline has enormous implications for the cartel's members, as nearly all of them need the revenues to keep their welfare and warfare states fully funded. The decline must be especially painful for Saudi Arabia, the leader of the pack, which announced plans last year to sell part (estimated to be between five and ten percent) of its precious Saudi Aramco oil company. The company, thanks to deliberately opaque disclosures, was estimated to be worth, depending on the price of oil, between $2 trillion and $10 trillion.
That's the operative word: “depending.” OPEC had big plans for the funds it hoped to raise, encapsulated as its “Vision 2030.” As Mohammad bin Salman bin Abdulaziz Al-Saud, the nation's Chairman of the Council of Economic and Development Affairs, wrote:
The first pillar of our vision is our status as the heart of the Arab and Islamic worlds. We recognize that Allah the Almighty has bestowed on our lands a gift more precious than oil. Our Kingdom is the Land of the Two Holy Mosques, the most sacred sites on earth, and the direction of the Kaaba (Qibla) to which more than a billion Muslims turn at prayer.
The second pillar of our vision is our determination to become a global investment powerhouse. Our nation holds strong investment capabilities, which we will harness to stimulate our economy and diversify our revenues.
The third pillar is transforming our unique strategic location into a global hub connecting three continents, Asia, Europe, and Africa. Our geographic position between key global waterways makes the Kingdom of Saudi Arabia an epicenter of trade and the gateway to the world.
That, of course, is going to take billions of dollars. As the world price for crude drops, so does the market value of Aramco. With the world price of crude now in the 40s, that grand plan is in danger of becoming more of a dream than a vision.
Reality is setting in as OPEC's production cut agreement, recently extended, is coming undone. Thanks to production from Libya and Nigeria – two of the cartel's members which were given a pass on complying with the agreement – and surprisingly strong production from American frackers, oil is reflecting simple economics: production is stronger than demand.
And that's not likely to change, either. As Robin Wehbe, the managing director of the Dreyfus Natural Resources Fund put it: “It's alarming to people because this cycle has played out very fast. The oil market has gone from a cartel-managed business to an open-market-driven business.”
An “open-market-driven business” – that's a concept with which OPEC is unfamiliar, and it's relegating them to a mere footnote in history.
OPEC isn't getting any help from Dennis Gartman, editor and publisher of The Gartman Letter and commodities trader. In an interview with CNBC's Power Lunch last week, Gartman said:
There's a real problem out there in the crude oil market. You're going to get a rally and the market is rallying today [Wednesday, June 28]. It's been rallying for the past 4 or 5 days. [But] it is nothing but a dead cat bounce.
I'll go with the Deputy Crown Prince of Saudi Arabia, Mohammed bin Salman, who has made it abundantly clear that he thinks crude oil over the course of the next 20, 30 years is going to be essentially worthless.
Perhaps that's excessive hyperbole, but he has a friend in Goldman Sachs, which just reduced its forecast of $55 a barrel for the next three months down to $47.50 a barrel. In a note to clients, Goldman said that the resurgence of production from Libya, Nigeria, and the U.S. “creates risks that the normalization of inventories [i.e., the long-awaited “balancing”] will not be achieved by the time the OPEC's [production cut extension] ends next March. We expect this will leave prices trading near $45 a barrel until there is evidence of a decline in the U.S. horizontal oil rig count, sustained stock draw[downs], or additional OPEC production cuts.”
Reports from both the International Energy Agency (IEA) and the U.S. Energy Information Administration (EIA) indicate that new production is simply overwhelming OPEC's cuts, with little indication of any slowing of rig counts in the US, sustained drawdowns worldwide, or additional OPEC cuts in the future.
There's the compliance issue as well, something every cartel fears. As the price of crude falls, so do revenues for cartel members, most of whom (e.g., Venezuela) are in desperate shape. Many have built their socialist paradises around the premise and promise of unending flows of revenues as oil topped $100 a barrel. Now they are in deep deficit, and unless they see increased revenues through increased world prices, compliance with the failing agreement will falter. Wrote Carsten Fritsch, an analyst at Germany's second largest bank, Commerzbank, “OPEC's compliance will crumble soon. Low prices are causing them a lot of pain and some members will ramp up output to compensate.”
There could be a temporary reprieve for the fading cartel as record numbers of Americans are taking to the road for the Independence Day weekend. In addition, July is usually a big month for drawdowns from inventories as demand typically exceeds production briefly. So observers are watching particularly for reports from the EIA to see if those inventory reductions are temporary or permanent. David Thompson, executive vice-president at Powerhouse, an energy commodities broker in Washington, D.C., noted: “Typically June/July represents the seasonal peak in refinery demand for crude. It gets tougher to use up all that crude as refinery utilization starts to ease off as we move past the peak of summer driving season.”
There's another underreported factor in all of this avalanche of bad news for OPEC: there are 6,000 DUCs waiting to come online. A DUC – a developed but not completed well – has already been drilled and proved, expensed, and put into inventory, waiting for the right moment. That “right moment” is predicated upon the variable cost of bringing online a DUC – far less than the sunk costs already expended. With world crude oil in the 40s, those variable costs are making bringing them online more and more attractive. Just one more thing for OPEC to worry about.
Thanks to irreversible circumstances, mostly driven by America's free market in oil production, OPEC will continue to lose ground, influence, and credibility. Its halcyon days are behind it, and few are lamenting the fact.
Sources:
Reuters: All eyes on July for U.S. oil demand to drain glut
Wall Street Journal: Oil Enters Bear Market as Investors Lose Faith in OPEC's Cuts
CNBC: Goldman Sachs slashes oil price projection amid US shale surge
Wall Street Journal: Oil Price Outlook Darkens
CNBC: Dennis Gartman: ‘There's a real problem' in oil market, bounce won't last
CNBC Profile on Dennis Gartman
Organization for Economic Co-operation and Development (OECD)
Background on Germany's Commerzbank
Drilled but Uncompleted Wells (DUCs)
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