October 13, 2014

Oil could move below cost of production

It is hard, if not impossible, to imagine a world without OPEC. But just as we are constantly trying to find Black Swans before they appear, if OPEC ceases to function or its influence wanes, it could be a possible "Golden Swan" that no one sees coming. The ramifications of this would be profoundly positive for global economies  and markets.

Powerful forces are now forming to suggest OPEC's days are numbered and that, at the very least, its impact will wane.

 -   The Growing Influence of the U.S. on Energy Production -- The U.S., through hydraulic fracking, has become a major oil producer and our imports have fallen, helped by secular efficiency in consuming energy.

 -   Subpar Global Economic Growth -- A global slowdown (influenced by structural headwinds) has served to reduce oil demand, particularly in Europe and China. Oil is priced in U.S. dollars and the dollar rise has made oil more expensive and has moderated consumption.

 -   Leading Suppliers Are Raising Production -- A few major producers are motivated to increase production and steal share rather than cut production (the usual OPEC strategy in times of slack demand). Saudi Arabia did so last week.  Stability of its budget requires maintaining oil revenue (at about $90 a barrel on previous production) rather than cutting it. If prices fall below $90 a barrel, the Saudis indicated last week they will cut price to maintain revenue, worsening any supply glut.

-    Russia's Economic Woes -- Russia (not a member of OPEC) has deepening financial troubles. Oil is its principal export. Its currency is falling and its oil is priced in U.S. dollars. Logic suggests Russia will desperately raise production.

-    Others Have Issues -- Three producers with excess capacity have issues. Iran and Iraq are Shiite entities. If the Saudis surrender share to them, it will help their cause. This seems unlikely. The Arab Spring has left Libya in shambles and it is producing to rebuild.

-    Venezuela Is a Wild Card -- Venezuela could usually be counted on to withhold production. Due to its inflation and recession that is unlikely to happen.

It looks increasingly possible that OPEC has wandered into a perfect storm. 

For one reason or another, members are unlikely to cooperate in withholding production to maintain price. 

Over the next 1-2 years the price of oil may move  below the marginal cost of production. This could translate into sharply lower energy prices and consequently higher consumer real incomes (and spending) than anyone is forecasting. IF this happens, the overall market should be ignited to the upside, with particular strength in the consumer and transportation sectors and with weakness seen in energy production and exploration issues. The relatively positive action of the retailers over the last week or two might be an early signpost that the role of OPEC is diminishing and that the price of energy products might continue to decline.

The bottom line is that a lengthy period (54 years) of the pain of inflated energy prices may now be coming to an end in what might be called a Golden Swan of Lower Oil Prices. 

To say the least, the OPEC meeting late this month should be interesting.

VIA http://www.thestreet.com/story/12906860/1/doug-kass-a-dissolution-of-opec-could-be-a-golden-swan.html