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August 16, 2016

Why OPEC Won't Strike a Deal on Oil

By Dr. Kent Moores, Money Morning
After a more upbeat start to the week, oil prices fell and hovered around $42 a barrel for WTI (the main U.S. benchmark). It looks like we're settling into another period of range-bound oil.
Oil's initial move up this week was caused by some OPEC members calling, once again, for a cut or "freeze" in oil production.
Traders, who need to literally hedge their bets on forward contracts, responded by nudging the market up. Yet there was little substance to these rumors.
Now, it's true that every single member of OPEC is suffering from low oil prices – and some much more than others.
But the truth is, Saudi Arabia has burned too many diplomatic bridges to get any deal like that off the ground…

Every OPEC Member Is Suffering from Low Oil Prices

For quite some time, a number of OPEC countries have been in dire straits over low oil prices. In fact, every single member of the cartel is taking it on the chin with budget deficits, including the most solvent of them – Saudi Arabia, the United Arab Emirates, and Kuwait.
The Saudis have even increased taxes, cut expenditures, and moved back into the global bond market for the first time in years.
But it's the likes of Venezuela, Nigeria, Libya, and Algeria that have been hit the hardest. All are facing acute financial meltdowns, with the accompanying escalation in inflation, unemployment, shortages of food and other staples, and rising unrest.
Venezuela's capital is witnessing the worst food riots in decades, while Nigeria is undergoing an intensifying wave of conflict in the oil-rich Delta region. Libya, meanwhile, is flat out undergoing a civil war.
Each of these OPEC members requires oil to fetch more than $120 a barrel for any pretense of a balanced budget. In the case of Venezuela, that figure is even higher – a staggering $180.
Despite its bluster, Iran is in an only slightly better position…

Iran Is Suffering More Than Most

Behind the official announcements of a resurgence in production and exports, Iran's economy and its collapsing oil infrastructure show what a financial mess the country is in.
In fact, contacts in Tehran continue to tell me that their target price is well above $100 a barrel.
Against this backdrop, it's understandable that some OPEC members will from time to time float the trial balloon of an impending agreement on capping production. And, as happened earlier in the week, there will be a short-lived spike in prices.
Here's why, even though few traders really believe in these rumors…

Russia Is the Key to Any Oil Deal

It's important to remember that oil traders peg their contract prices not on the cost of the current barrel of oil, but on the expected next barrel. If there is a rumor – in either direction – it will be reflected in the contract price. However, this is very much a "set the contract price on the rumor; use options to settle the price on the fact" kind of situation.
Leading up to the non-event meeting in Doha, Qatar, several months back – the one that resulted in no agreement on production caps – the focus was on whether Russia would agree with OPEC on limiting production.
It was thought that Moscow might hold the key.
That's because Saudi Arabia and the rest of OPEC will never cap the oil it moves into the global market without having an assurance that producers not in the cartel would be doing the same.
And Russia is important as the largest non-OPEC oil provider in the world with central control over production. In other words, an agreement made by the Kremlin can quickly translate into a national policy of lower production.
Now, the rise of shale and tight oil actually propelled the United States above Russia into the spot as the world's largest non-OPEC producer. But the American market is a very decentralized production environment. Even if Washington were to show up at an international oil meeting, the government has no power to negotiate for the thousands of private U.S. producers.
Russia, on the other hand, has concentrated clout and can dictate domestic production levels. And as long as Russia is on board, OPEC can still make do without the United States…

There's No Trust Left Between Saudi Arabia and Russia

You see, OPEC and Russia together could offset U.S. oil production by limiting price rises without too much trouble.
In any case, the current rumors about production caps are coming to an abrupt halt. Russia has declared it will not agree to a cap, preferring to maximize exports in a barrel-by-barrel contest with OPEC.
Moscow is still reeling from the meeting in Doha earlier this year, where the Russians thought they would have an agreement in principle for a cap only to find Saudi Arabia sabotaging the talks at the eleventh hour. Riyadh suddenly declared that there would be no cap if Tehran was not on board.
Russia, of course, has its own central budgetary problems to worry about. But it has decided that, until there is some firm indication that OPEC will be cutting its historically high production levels, it will not do so either.
We are, therefore, back to each competitor defending market share, with pricing cuts used to wrestle export markets from other producers. This was the reason for the Saudi move I discussed last week, a move directed squarely against Russian exports to Asia.
Despite what the more desperate members of OPEC may prefer, there will be no accord on capping production levels before the first quarter of 2017. That's when a real balance between supply and demand may take root in the oil market.
Until then, and with the continuing caveat that there are no unexpected geopolitical events coming, expect range-bound trading until the last quarter of 2016.
We may see a more sustainable move up in price setting in about then.
At the same time, there's no real threat of a collapse in oil prices. Despite what the short artists would like you to think, the price is hardly going back down to $30 a barrel.
Courtesy of Dr. Kent Moores, Money Morning
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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