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December 17, 2014

The Russia, Mexico & OPEC Failed Agreement on Production Cuts was Short Sighted

By EconMatters

Vienna Short-Term Greed

Remember several weeks ago when oil was still trading around $75 a barrel, and OPEC was deciding upon a production cut, Russia and Mexico went to Vienna where a deal was being discussed regarding a combined production cut so that Saudi Arabia wouldn`t have to take the brunt of the cut by themselves? Looking back this has to be one of the most shortsighted business decisions of recent history, and ironically it will end up costing them more money and doing more harm to their countries balance sheets than losing a little market share to the US shale Industry for a couple years until it runs its course.

Let`s Have A Price War!

I get the simple reasoning, there is a lot of that going on these days. In fact most of Wall Street and Modern Financial theory lacks sophisticated logical reasoning found in other disciplines like Philosophy, Technology & Science. So the simple reasoning by the OPEC decision not to cut production is that “Why should we be the ones to cut production and possibly lose more market share to the US Shale Industry”? Why not talk down price, give the speculators more fuel to work and pressure prices further causing the US Shale players to cut back production, or go out of business entirely, and then they( mainly the Saudi`s who have the lowest production costs) can gain market share after the short term inevitable pain (however long that ends up being).

Sophisticated Cost Benefit Analysis

There are a couple of reasons why this strategy is not the best strategy they could have chosen, first of all the US is a diversified economy, sure the Shale Industry will be hurt with lower oil prices, some of it may even go out of business, or be bought up by larger companies in the US. However, the rest of the United States is going to benefit from lower fuel costs, and the US economy as a whole is going to better off from lower oil and fuel prices and flourish. Whereas the OPEC countries are not diversified, their main source of revenue is oil, so not only do they get lower revenue from lower oil prices; but this just doesn`t hurt their budgets, their balance of trade, or the oil sector of the economies, it hurts their stock market, it hurts their financial sectors, in short every part of their economy is affected from building and real estate stocks to restaurants and the entire supply chain that relies upon healthy oil prices to fuel its economy. Most of these countries subsidize fuel so the consumer in these countries doesn`t really even benefit that much with lower fuel costs as a result of the drop in oil prices like net consumer nations.

Throw Russia and Mexico in this category as well when one evaluates not just the lost revenue due to lower oil prices, but look at how Russia is spending a ton of resources trying to prop up its currency, and the entire system is under considerable distress. So weigh in the lower oil price on the currencies as well in a cost benefit analysis of not agreeing to production cuts and this being a good overall strategy to employ. Did Russia factor in the Inflation costs on its country when making the decision to walk away from production cut talks?

Evil Oil Speculators Can Switch Sides

But there is an even bigger point OPEC didn`t consider because it has been a long time since the oil market has been weak, and frankly modern energy speculation in electronic markets wasn`t around in the 1980`s like it is today. Remember how OPEC used to always blame really high oil prices on the speculators, well they didn`t think about the magnitude of waiving the white flag, and letting these same speculators go to town on their primary business product. I guarantee you they didn`t see oil prices dropping this fast, and hurting their revenue streams this much. But there is a bigger point, oil is an asset, and you don`t just give it away for free, this isn`t a fall inventory sale at Macy`s, it has long-term value, if you aren`t getting a viable cost, you hold onto the asset, as it is a finite asset, and has greater long-term value in the future. OPEC, Russia, and Mexico are essentially wasting their limited resources, giving these finite resources away to consumer countries at a sharp discount, this is just bad business strategy, it cheapens the asset`s value. De Beers in the Diamond Industry understands this concept, this is what cartels do, they control price, and they never sell or cheapen their assets in a public manner. No business should ever willingly allow shorts to attack their product and make it less valuable, this is just poor business strategy. OPEC had created quite the illusion that their asset was valuable, worth over a $100 a barrel, consumers were willing to pay this high price, the last thing you do as a cartel is alter this perception in the public. It is just a poor branding strategy, Apple would never do this!

We said it first: Brent Oil Faces Headwinds in 2014  (Jan. 16, 2014)

Best Option for OPEC in Hindsight

This is what should have happened before the OPEC meeting, Russia, Mexico and OPEC members should have agreed to cut back global production by 2 million barrels per day, when you spread it out it isn`t that much, and they would have all netted more revenue from prices higher in a stabilized market around $100 a barrel (almost twice what it is today). And yes it would make a difference shoot there is probably $25 bucks worth of price regarding shorts in the oil market right now! Think if the shorts covered on a production cut of 2 Million Barrels Per Day at $75 a barrel in WTI, this probably gets WTI back to $100 in two weeks. There is a lot of value in maintaining a sleepy range bound market, the last thing OPEC should have wanted to do was Draw Attention to Sharks that Oil was Ripe for taking down, as they were going to attack their currencies, stock markets and anything else they could find to exploit as well in the feeding frenzy.

Remember oil is a commodity, it has no real value, as we have seen it can be $55 or $105 on no real significant difference in supply, it is all about perception and market sentiment, in other words marketing or branding of the commodity. But look at all the damage to the Cartel member`s stock markets, their currencies, the confidence of their people; and the short-sighted nature of their failure to cut production looks horrific in hindsight despite the public rhetoric of OPEC members. Plus you have more of your primary asset that you can sell in the future when prices are much higher. Let the US Shale producers waste all their asset right now, who cares if they gain 5% more market share on a temporary basis? These people let short-term greed, and a lack of understanding of basic finance and business strategy cost them a whole lot of money when all is calculated with this experiment. “Why should we be the one to cut” because it is in your best interests to cut – the failure here was thinking about their situation in relation to the US Shale Industry. This is completely irrelevant, what is in your best short-term and long-term best interests? It does OPEC no good to hurt the US Shale Industry; or Russia, Mexico and OPEC to avoid production cuts if it hurts them more than the alternative option of production cuts. This should be their sole focus, they got distracted in their cost benefit analysis by thinking about the US Shale Industry and the whole short-term market share issue! Moreover, this is what Cartels do, this is why OPEC formed in the first place to protect its primary asset, control production, and to promote and maintain the brand status of this commodity! Don`t let ego and pride get in the way of a sound business decision! What is the best business decision keeping more of your primary and limited asset, and overall still getting more revenue, helping your economies, stock markets, currencies, and maintaining the illusion that you own a valuable and limited commodity in oil?

Yes Branding Matters in the Oil Market – It`s time for OPEC, Russia & Mexico to start acting like a Cartel – Remember the Oil Market can be Commoditized or Branded – The Answer to “Why Should You Be The Ones To Cut” is because you don`t have Diversified Economies

De Beers even goes so far as buying up black market supply and taking it off the market to control the Diamond Market, the last thing De Beers or Apple is going to do is cut their highly branded product in half to win some market share, you get lower margins for your product. Remember Russia all you had to do was agree to take a small share of the pain of a production cut, sure looks like the best option right now, considering the fact that you had to go to the extreme of a 17% interest rate or bailout Rosneft, it would have been much cheaper just to take a 400,000 barrel per day Oil Production Cut, maybe even less of a Production Cut!

This Problem has some characteristics of a Prisoner`s Dilemma/Nash Equilibrium Scenario for OPEC regardless of what happens with the US Shale Industry, OPEC, Russia & Mexico are always going to be Worse Off by Not Agreeing to Production Cuts 

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