The End of OPEC; America's Winning Hand

December 14th, 2014
in econ_news

Special Investigative Report from Money Morning

by Kent Moors, Money Morning

Every 10 or 20 years a series of watershed events come together that change the face of the international energy picture.

The Saudi-led oil war is one of these pivotal situations.

Follow up:

And while others are fretting about what the OPEC production move means, I'm actually meeting with the guys who made the decision.

I can tell you that what's unfolding here in the desert will have a decisive impact on producers, end users, and government/corporate policymakers worldwide.

Of course, I've been involved in a fair share of all of this for over 40 years, from both the public and private sector side.

Much of that is coming together in my current slate of meetings with some of the most powerful people in the energy world.

What I learn in these gatherings will allow everyday investors to make some heavy money as these pivotal changes kick in...

Next Stop: The Financial Capital of the Energy World

The last leg of these foreign travels begins early Saturday morning when Marina and I depart Dubai for London. On the schedule are meetings with key figures in London's financial district, also known as "The City."

It's the final piece of a broader strategy I'm forging to benefit from the next big moves in the energy sector.

Central to these discussions will be the information I'm bringing from earlier sessions with bankers in Paris, dealmakers in Frankfurt, and OPEC members here in the Middle East. London is where it will all come together.

The reason is simple.

More money for oil and gas deals is raised in the three-mile radius from the Liverpool Street station in London than anywhere else in the world. Whatever is developed elsewhere more often than not ends up being bankrolled in "The City."

But before I begin with what I am taking with me from the desert, I need to make one point up front: So little of what you are hearing from the pundits has any relationship to what's really coming in oil. The majority of the information flowing from the "instant analysts" on the tube is incorrect.

The American Petroleum Institute figures released yesterday, and the EIA weekly report coming out this morning, will both show a major drawdown in crude oil inventories. But the supply has not been affected - a cutback in U.S. tight and shale oil production will actually take some time to develop, if it happens at all.

So all American-based crude oil projects currently underway, all wells to be spud, and field production plans will continue as scheduled. There will be a consolidation coming, featuring a combination of some companies becoming smaller and others being absorbed in a major round of M&A.

That means one of the three major underpinnings of the Saudi-inspired move won't go as planned for the kingdom. It indicates the weakening of OPEC's real influence in contemporary oil markets, and likewise illustrates the cartel's rising desperation.

Now don't get me wrong. Saudi Arabia has plenty of reserves, as do some other cartel members. There are no plans any time soon for a bake sale to raise revenue for these countries.

But the main OPEC producers don't exactly have diversified economies, and rely on exporting raw materials while importing just about everything else.

Even the Saudis are running an expanded budget deficit. Of course, Riyadh's current hard currency reserves could easily support that deficit for the next three generations. And that means this is not essentially about money, at least for the dominant producer in OPEC.

For the Saudis, it is about something else entirely: Leverage and influence.

My suggestion earlier this week that last week's production decision has only bought OPEC a few years seems right on the mark. The cartel is rapidly losing its ability to establish international prices.

Controlling 40% of the world's oil production just doesn't buy what it did a few years ago.

OPEC has not set prices directly for some time in any event. Rather, it has attempted to control the supply. Each month it estimates global demand, deducts from that non-OPEC production, with the remainder being something referred to as "the call on OPEC."

That "call" is then divided among OPEC members into monthly export quotas.

Except that formula has been broken for some time, leaving the Saudis, as the main balancer within the cartel, in a difficult position. The Saudis are left to offset pressures within OPEC against external factors over which they have fading real control.

OPEC's Days are Coming to an End

All of this leads us to three separate reasons why the days of OPEC as an energy monolith are numbered.

First, the ranks are breaking within the organization. Saudi Arabia, Kuwait, and the United Arab Emirates (of which Dubai is one of the seven members) can withstand the present price reductions. Others in OPEC cannot.

Leading this list of weaker members are Venezuela, Nigeria, and Iran. Each requires a price per barrel of more than $100 to fund their very precarious central budgets. That has already caused these three (and others in the group) to exceed their monthly quotas. They have been forced to sell more for less, and the Saudis can do little about it.

Of course, that merely exacerbates the global picture on the supply side. As this environment persists, OPEC speaks less as a single (Saudi-led) voice. The cartel is fraying and the situation will deteriorate even further following the Iraq-Kurdistan agreement yesterday, which is certain to open the market to additional Iraqi exports.

Coming out of a prolonged period of conflict, Iraq doesn't even have a monthly OPEC quota yet. When it does receive one, Iraq will be poised to increase exports significantly and will be moving volume at the expense of other OPEC quotas. Don't expect that to go down easily among the other members.

As for the other two fronts, they are external - the battle with Russia over the Asian markets and the duel with the U.S. over unconventional production.

I've discussed both of these fronts several times, but my meetings have indicated an increasing urgency in the tone in which they are addressed.

Asia is now rapidly becoming the biggest target for oil (and other energy) exports worldwide. That trend will be increasing in an uninterrupted curve through at least 2035. Saudi oil exports have been dominant in the region, with Asia regularly paying a "premium" above rates for the same Saudi oil delivered elsewhere in the world.

But now the Russians have moved in. With the opening of an historic East Siberia-Pacific Ocean (ESPO) export pipeline, Moscow has begun to move crude of better quality than the Saudis export to Asia, at discounted prices.

Riyadh first cut the price to Asian consumers in a direct confrontation with the Russians. And by refusing to allow an OPEC production cut last week, the Saudis are deliberately trying to reduce the price globally. At $70 a barrel, oil prices are a full $15-20 below the level needed in Moscow to balance its budget.

But don't worry; Russia is not going to collapse either. It also has ample reserves, and recently allowed the ruble to float. Yet MinFin (the Russian Ministry of Finance) does acknowledge that the country will fall back into recession as early as the first quarter of next year.

Monday's announcement that Moscow would scrub a $32 billion natural gas pipeline through Bulgaria (South Stream) in favor of an as yet to be negotiated venue through Turkey is an indication the Kremlin needs to make energy revenue adjustments.

Asia, however, remains the primary prize and the main point of contention between OPEC and Russia. Officially, Putin is pledging his support for the OPEC production move (since it has no impact on Russian production levels), but privately Russian officials are fuming.

America's Winning Hand

Finally, there is the factor drawing the most attention by the talking heads on TV. By keeping the price low, Saudi Arabia is also attempting to stifle tight and shale oil production in the U.S.

But as I've noted on several occasions, that only has an indirect effect on global oil prices. OPEC can only impact the American market by what it exports there, and only in that way does it have any effect on world pricing.

There is a straightforward reason for this. U.S. producers are still prohibited from exporting most types of crude. Unfortunately for the Saudis, that is about to change, creating very direct consequences on broader pricing from U.S. production.

American crude exports are coming and there are two related components here. There are now plenty of excess recoverable reserves in the U.S. So exporting would have no effect on already declining prices in the domestic market. That removes the primary political objection to U.S. exports.

On the other hand, the tight/shale oil and gas revolution is having a major positive impact on employment, local tax bases, and economic development. A subdued pricing environment may call this into question.

Exporting, on the other hand, would become a major continuing stimulus.

So as we head into 2015, OPEC has revealed its cards and they aren't playing a winning hand. Instead, a response is about to follow that involves the export of liquefied natural gas (LNG) from the U.S. beginning within the year, and prospects for straight crude exports (or allowing additional minimally processed volume to follow already approved exceptions to current legislation).

The network that will bring down OPEC policy includes North American production, consumers worldwide, and financing delivered from some unlikely sources.

All of which makes my upcoming meetings in London that much more interesting. I'll have more on this as it develops.

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