Why OPEC will never cut production again - MarketWatch

4/21/16, 3:03 PM

Why OPEC will never cut production again

By Kirk Spano
Published: Mar 2, 2016 10:31 a.m. ET
Since the December OPEC meeting, I have come to one
inescapable conclusion: that OPEC will never cut production
again at the expense of its own market share. Based on that
idea, in the past couple of months, my clients, subscribers and
I have done well to trade around oil's further decline, the slow
bleed out of indebted oil stocks and even bet against a few
banks. In the past week, however, oil has shown some
strength on the back of young traders and short covering. With
huge resistance around $37 per barrel of oil, I don't see that
strength lasting long.
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Back in late 2011 I identified at about the same time that

several institutions did that the U.S. shale industry was
going to change the global energy dynamic and recommended buying oil stocks. By 2014, I recognized that the price
of oil would collapse, suggested selling oil stocks and invested in the dollar. In 2015, I made the same mistake that T.
Boone Pickens admitted to recently, in that I, too, believed the rebalancing of the oil market would happen much faster
than it has. The result was that I gave back a lot of 2014's gains.
The end of Saudi subsidies
But now times have changed again. Here are my reasons for OPECs actions. First and foremost is a question of logic.
Why should the lowest-cost producers of oil subsidize the highest cost? In what we know is the beginning of the end of
the oil age, it simply doesn't make any sense to let the highest-cost producers survive when the entire oil industry is
slowly gliding toward a form of long-term business run off. It is not in the interest of the low-cost producers to cut
production when the market will eventually kill the high-cost producers.
The International Energy Agency also just came to the same conclusion: "In 2016, we are living in perhaps the first
truly free oil market we have seen since the pioneering days of the industry." If that's the case, low-cost producers will
produce as much as possible from here on out. Oil-price increases will come from lower output from higher-cost
producers who can't finance questionably economic new projects going forward in most cases.
Saudi Arabia has no intent to cut production. Their freeze agreement with Russia and a few others is simply an
acknowledgment that they have reached the point where they want to be. Anybody who listened to or read Crown
Prince and defense minister of Saudi Arabia Muhammad bin Salman's interview in January (The Economist) should
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Why OPEC will never cut production again - MarketWatch

4/21/16, 3:03 PM

have no doubts about his resolve. He realizes the power of the kingdom's oil and is going to use it.
One clear sign that Saudi Arabia has no intention of cutting production is the likelihood that they are taking Saudi
Aramco public. By doing this, Saudi Arabia can claim that they are not in control of oil production, the same way that
Russia and western nations do when they point out their oil companies are privately owned. By taking Aramco public,
the Saudis can take a windfall and create a cash-flow machine for the royal family and the country (presumably). I
could see a small cut in Saudi oil production just ahead of taking Aramco public to goose the IPO, but not likely before
then.
What about the other players?
Iran has stated that they will increase production by a million barrels per day over the next year. While they probably
miss on that target, there is no doubt they are on a path to much higher production. The rest of OPEC will never cut to
offset Iranian production entering the market over the next two years when higher-cost oil will die anyway.
Iraq, while they have signed off on the freeze, is only partially signing off. The Kurds in the north, who operate
independently (though maybe not completely legally), are not going to stop increasing oil production short term. Longer
term, Iraq is unlikely to hold the line as they need more revenue to rebuild.
Libya is over a million barrels per day below their normal production due to the civil war there. At some point, that
production will come back to the market, as they too will need to rebuild.
Non-OPEC adjustments
So, over the next year or two, there is virtually no chance that OPEC cuts production. After that, they might cut
production slightly to maintain pricing, but not at the expense of market share. We will continue to see the adjustments
to supply come from non-OPEC higher-cost producers depleting assets and not reinvesting. OPEC will not only keep
their market share, they will increase it by a couple of million barrels most likely. I've come to agree with those who
think the oil market won't clear until the price of oil hits $20/barrel or lower for a day or two likely sometime this
spring, in my opinion and trades in a range of $25 to $45 for a period as the National Bank of Abu Dhabi PJSC
recently suggested.
For investors, the idea of value hunting in the oil space has become slightly more popular lately, particular betting on a
rise in oil prices. The Velocity Shares 3x Long Crude Oil ETN UWTI, +8.67% has been among the most active
vehicles of late. It is a very risky bet in my opinion, as the long-term trend is against it. Traders using that fund are
betting on a reversal that is probably not here yet.
Disclosure: Kirk Spano and certain clients of Bluemound Asset Management do not own any security mentioned.
Subscribers to Fundamental Trends have no recommendations to buy any security mentioned. Neither Spano nor
Bluemound clients plan any transactions in the next three trading days. Opinions subject to change at any time without
notice.

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