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OPEC has agreed to stop oil prices soaring

Image: BP plc. Fair Use.

We recently saw a big decision by OPEC – the group known only to their mothers as the Organization of the Petroleum Exporting Countries.

In the face of near-universal scepticism from fund managers and market commentators, OPEC agreed for the first time in eight years to cut the volume of oil its members produce.
 
In fact, the deal to reduce output by 1.2 million barrels a day reached beyond OPEC. Non-member Russia also agreed to curb output.
 
Of course, having universally dismissed the prospects of a deal beforehand, many of those fund managers and media pundits were quick to explain how obvious it was that OPEC would reach an agreement.
 
Ho hum.
 
But their scepticism soon found a new avenue to go down. Within a day or two, there was a fresh consensus developing that OPEC probably wouldn’t be able to enforce the agreed cuts.
 
The oil price might top $50 a barrel, the market’s chattering classes agreed, but don’t expect it to last.
 
There’s too much oil around. Prices will fall again.

The never-ending story

Not for the first time in my life, I see things differently to most.
 
In my view, the biggest implication of OPEC’s agreement is that oil will probably be cheaper in a few years than might have been the case had OPEC not agreed to cuts now.
 
That seems counter-intuitive, right? Prices are rising on the deal, and there’s going to be fewer barrels of oil about.
 
How could that result in a lower future oil price?
 
The answer is that any commodity sector is driven by boom and bust.
 
In the boom phase, demand increases, prices rise and companies overinvest to boost production with ever more expensive-to-extract barrels of oil (or lumps of coal, or nuggets of gold). Often they take on debt to try to build out faster than their competitors. A little more interest seems almost laughable in the face of surging sales.
 
But eventually all that extra supply saturates demand. Nobody wants the extra – or marginal – barrels. Often the latest supply comes from the most expensive places, too. (There was a reason it wasn’t got at before…)
 
Now markets do what they do best, re-pricing to reflect the glut. Prices crash, fields become uneconomic, debts turn fatal, and firms go bust.
 
To survive, those companies (and countries) who can begin to react. Expensive facilities are mothballed. Service companies sweat. Future expansion is abandoned, and its planners fired. Dividends are slashed. Cash is king.
 
Ironically output may still increase, as the strongest players with the best assets seek to maintain their sales and market share by ramping up volume, albeit selling at reduced unit prices. Demand can increase, too, in response to the falling cost.
 
But a glut is a glut, so until the extra demand is sufficient to clear the excess inventory and match supply, prices languish.
 
Eventually, though, a balance is reached. At last prices rise.
 
And off we go again!

We were nearly there yet

My view is that the oil market was rebalancing, even without OPEC.
 
The OPEC cut seems to me more about trying to support national incomes battered by lower prices. Countries like Saudi Arabia and Venezuela desperately need more money.

The Saudis also seem set on the flotation of their State-run oil behemoth, Saudi Aramco. Higher oil prices would help that IPO, too.
 
But even if they hadn’t cut, the cycle is playing out.
 
Capital expenditure reductions have been tremendous.
 
As much as $1 trillion that would have been spent between 2015 and 2020 won’t be, because of low oil prices, according to consultant Wood Mackenzie Ltd.
 
This retreat will have a direct impact on the amount of oil the world is producing in a few years’ time.
 
Oil is – obviously– a non-renewable asset. Once pumped, it’s not replaced.
 
That means the exploitable resources of existing oil fields decline.
 
But they’re also impaired by factors such as declining pressure and more water content, especially if money isn’t spent maintaining them.
 
And that is just the oil fields we know about.
 
In a downturn, blue-sky exploration – wildcatting – is curtailed. Which means fewer new fields to replace those dwindling current assets.
 
Wood Mackenzie reckons cost cutting has already slashed 5-6 million barrels of daily output from what was expected before the oil price slump.
 
This dwarfs the reduction agreed by OPEC.

Curbing their enthusiasm

Of course, you’ve read that shale and tight oil in the US will come back online if and when the oil price rises.
 
To which I’d say – let’s hope so.
 
I don’t believe US oil production will cap oil prices. Certainly it will help meet future demand, but I can foresee a scenario in which it is not sufficient to make up for an upcoming shortfall.
 
Which is why I think OPEC has actually dampened future price rises.
 
If it hadn’t taken action now, those capex cuts would probably have continued for another 6-12 months before the excess of oil was finally cleared, finally sending prices higher.
 
Who knows how high the price might then have gone in a world without enough oil to go around? We currently consume 96 million barrels of oil a day – around an all-time high. We need to constantly find more.
 
With the OPEC cuts, however, the oil price should move higher sooner rather than later.
 
This means further capital expenditure cuts will be forestalled, and new fields eventually opening up.
 
Like this, we might avoid the oil price hitting say $150 in 2-3 years’ time.

A fresh burst of energy

Does this all make investing in the energy sector a sure thing?
 
Not really. You see, a higher oil price also increases the competitiveness of rival renewable energy sources such as wind and solar.
 
Now I’d argue we need higher oil prices for precisely that reason. Without it, manmade climate change will be made worse by even more years of burning cheap carbon-spewing fossil fuels.
 
It’s the threat (or opportunity) of renewable energy that is the big existential challenge for oil company investors, and for OPEC.
 
But for now I suspect the recovery in the oil sector has only just begun.

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