While we can’t deny a formal production cut tomorrow will induce a short-term pop to oil prices, the follow-through will be short-lived.
Consensus was more one-sided on expecting a production cut when we circulated our first note on OPEC’s waning influence toward the end of October:
While the market has priced in this clear shift in sentiment even though WTI is -10.4% since the October note, consensus is still divided on the outcome of the meeting. We expect any decision to induce an active Friday in markets. Volatility buyers feel the same.
Note: Without reading about this volatility set-up know that options markets are pricing in the uncertainty embedded in the market’s expectation for the outcome of the meeting. The market is pricing-in the expectation for much higher volatility (assumed annualized 1-standard deviation price movement) near-term than it has realized over the last 1/3/6-months….
- Rolling realized volatility in front month WTI Crude is 24%/23%/19% going back 1/3/6-months
- At-the-money put- implied volatility for Jan 15’ is trading near 38%, which is +24%/+41%/+74% above trailing averages over the last 1-6 months
- Looking at the skew of the chain going back every week in November reveals the heightened levels of uncertainty into the event. The shape of the surface has remained proportionally the same while volatility across the whole chain has been bid up significantly
We don’t gamble by positioning ourselves in front of events, but we can certainly study consensus positioning and the expectations for volatility vs. what it has realized over going back in time and tell you that any decision is going to warrant a volatile Friday.
Before dethroning OPEC as a powerful cartel that pushes and pulls oil markets, let’s look at those parties who are perfectly comfortable with the overstated hora of OPEC as an organization:
1. OPEC members themselves which is self-explanatory from a political standpoint
2. Financial market participants who live off volatility
3. Oil companies who like higher oil prices and can use OPEC as a scapegoat for pushing prices higher
4. The media because they need something to report
Our expectation is simple…
WE DON’T EXPECT A FORMAL PRODUCTION CUT FROM OPEC OUT OF THE MEETING AND THIS WILL PUT MORE PRESSURE ON OIL PRICES (in addition to the quant set-up and #QUAD4 deflation which we have continuously outlined).
As mentioned above, we do not doubt any decision will provide a short-term move in spot markets, but from an intermediate to longer-term perspective, the decision is irrelevant:
OPEC IS NOT A FUNCTIONING ORGANIZATION AND QUOTA LEVELS HAVE NO BEARING ON HOW MUCH COUNTRIES ACTUALLY PRODUCE.
OPEC member representatives underestimate the longevity of other non-traditional plays, especially U.S. shale. We have no reason to believe OPEC officials know much about the technological advancements in shale extraction have brought down the break-even costs of U.S. shale plays. We hosted a call with Leonardo Maugeri who has consulted with the Sec. Gen. of OPEC, and he provided support to this reality.
In 2013, OPEC referenced an average per unit cost of production of $90/barrel for U.S. shale plays and this year they’ve said $70/barrel. On a longer -term horizon, OPEC members anchor on the idea of peak oil in the global marketplace, meaning their influence only has upside from here.
Remember that OPEC currently produces 40% of the world’s oil, but they hold an estimated 60-70% of proven reserves. They are more focused on near-term market share and long-term relative positioning against one another supporting prices.
Do we think that Saudi Arabia is ready and willing to come to Venezuela’s rescue when Venezuela has the second highest (behind Saudi Arabia) level of crude reserves on earth? No, we do not.
OPEC total production levels are below the 2012-13 period and we expect the inflection to higher levels to continue from here barring geopolitical discontent. The biggest perceived risk near-term is that they will continue to lose market share.
With some of the Gulf States having the lowest production costs on earth, they are fine with lower prices (especially if they carry the perception of squeezing non-traditional plays).
Saudi Arabia holds almost all of OPEC’s spare capacity and we do not think they will be willing to further production cuts.
As outlined in section 11.C. of OPEC’s statute, a formal production cut from OPEC technically requires a unanimous decision from the one representative member of each nation (unlikely considering the near-term incentives outlined above).
Now, assuming OPEC members band together and agree to a production cut, let’s take a look at how irrelevant these quotas have been throughout history…
Jeff Colgan of Brown University performed an extensive study of OPEC from its founding in 1982 and found that OPEC countries cheated (out-produced) their quotas 96% of the time.
- OPEC ANNOUNCEMENTS have an ability to move spot prices for about 15-20 days, but there is no evidence that production levels are at all influenced
- The correlation between OPEC quotas and oil prices is non-existent (r^2 =.15 since inception in 1982)
- During this period all OPEC nations except Iran and Venezuela over-produced 80% of the time based on monthly observations
- The nine principal OPEC members produced on average 10% above their respective quotas in this period.
- From 1 there were 22 OPEC meetings where quotas were increased, and in 21 cases, the increase in quotas were still below what each country had produced the month before quotas were raised
If OPEC is irrelevant, what happened in 1973?
While the chain of events leading to the embargo in 1973 is the one precedent that refutes our claim that OPEC as an organization is irrelevant:
1. We think the dynamic in the energy market was different; and,
2. The notion that OPEC curbed production by cutting quotas to jack-up oil prices in protest to the Arab-Israeli war is over exaggerated.
OPEC’s crude output in 1973 (embargo year) was 30.9MM B/D on average vs. 27.3MM B/D in 1972 (large increase), and OPEC maintained these price levels through 1974.
OPEC’s actions in that year were as follows:
- They increased posted prices (no longer in existence) which set the nominal price that international oil companies paid to extract oil from foreign fields. It was essentially a tax and royalty hike that followed what became a big spread in these royalty payments vs. market price per unit of oil. This did in fact lower oil company margins, and in 1973 OPEC raised posted prices from $2.90/barrel to $11.65 barrel
- OPEC made a push to encourage its members to nationalize their oil industries
- SOME OPEC members implemented a very short-term embargo against the U.S. and a few others. The embargo started in October 1973 and lasted for five months
Now posted prices are no longer a reality, the nationalization in the larger OPEC members is already complete, and the oil market is much more diverse, robust, and prepared to handle supply disruptions:
- More sources
- Higher stockpile levels in the major consuming countries
- More short-termism in contracting
Although the market has seen continued selling into the meeting tomorrow, volatility expectations, market sentiment, and OPEC’s decreasing influence are creating a set-up that will disappoint to support a move off of the multi-year lows.
If there is a cut, it will provide a short-term pop at the most holding all big macro constant.
Please ping us with any comments or questions.
Enjoy your Thanksgivings.