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The Most Important Part Of The OPEC Deal

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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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The OPEC Deal Represents A Permanent Shift In Oil Markets

OPEC

Market enthusiasm around the OPEC deal has vacillated significantly over the last week, alternating between optimism and pessimism. A healthy segment of investors view the current agreement with skepticism given the competing geopolitical interests of Iran and Saudi Arabia. And while that skepticism may turn out to be unwarranted; it is certainly possible that one or more of the OPEC members will cheat on any production agreement and overproduce, especially given the lack of effective monitoring mechanisms in place to control production.

None of that matters much though. The more significant point about the OPEC agreement that investors may be missing is the sign of shifting attitudes that it portends. An agreement between two foes as intractable as the Saudis and Iran suggests that OPEC has finally accepted an important reality – they cannot turn back time. While U.S. unconventional production has been curtailed, only a fool would believe it has been hobbled permanently. As oil prices start to rise, U.S. production will likely rise as well.

OPEC seems to have finally accepted the fact that they are not as strong as they once were, and that the market forces behind unconventional production in the U.S., Canada, and abroad are not as weak as OPEC had supposed. While a few U.S. firms have been bankrupted by the last few years, those bankruptcies have only served to strengthen top tier players in the space like Devon and Continental.

Far from shutting down U.S. production, OPEC’s actions have only helped to lower costs by putting pressure on the overall supply chain and associated prices. This has made unconventional crude more profitable at lower prices and exacerbated the problem that OPEC started with. Where unconventional crude producers once needed $80 per barrel oil prices to succeed, today breakeven levels are closer to $40. Related: Oil Holds Gains After OPEC Deal

OPEC appears to have finally given up the dream of crushing U.S. production and returning to a world in which the Cartel controlled the market. US producers may not be the lowest cost producers, but could well be the most flexible producers. OPEC’s actions did succeed in stalling new investment in future reserves development, but this hit both unconventional and conventional production in nearly equal measure.

If OPEC could have sustained a decade or more of low prices, eventually the curtailed E&P programs would have led to a structural shift in the oil markets and pushed new production down dramatically. OPEC never had that level of foreign currency reserves though. The Saudis would have needed at least $2 trillion more in reserves in order to sustain lower oil prices for a decade, and while that might be feasible for the Kingdom (with enormous asset sales and tapping international bond markets), most other members of OPEC would have run out of cash well before that ever occurred. To kill unconventional production, OPEC needed a scorched earth policy that its members were ill-prepared to adopt.

None of this means that oil is headed dramatically higher immediately or that companies will return the halcyon days of yesteryear. The market has changed. But OPEC’s production deal does signal acceptance of reality by the Cartel. Producers from the Saudis to Nigeria do not have the ability to withstand continued low prices. They are taking corrective action at this point because few options are left, and domestic political pressures are too great. Investors can capitalize on this trend. The current deal may or may not hold, but the game OPEC was playing for the last two years is coming to an end.

By Michael McDonald of Oilprice.com

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  • Jesze on October 05 2016 said:
    I'm not sure what your definition of a few is, but 90 oil and gas producers have filed for bankruptcy from 3 January, 2015 to 1 August, 2016. No doubt it will be over 100 by years end.
  • Bob on October 05 2016 said:
    It could be that the OPEC deal, in essence, represents total capitulation by the cartel. An agreement to reduce production in total but let Iran, Nigeria, and probably Iraq increase volumes as well as non members Russia, North America and North Sea increase doesn't seem to make much sense.

    Does it imply that the Saudi's will basically make whatever cuts are necessary to keep oil around $50 or so?

    I don't think that's likely. More likely is that the Saudi's felt they had to announce something positive just to keep the idea of a relevant cartel on the table. Maybe suggesting the group really has little to no long term power over oil price.

    Oil's eventually going to be higher but it could be this OPEC maybe deal pushes out that eventual big rise rather than having it sooner.

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