OPEC Pledges Another Production Cut

OPEC oil ministers decided for the third meeting in a row to lower the daily oil production quota coming from the 12 member cartel. The 2.2 million barrel per day cut is the largest pledged decline in OPEC history in the face of crude oil prices that have fallen more than 70% from record highs this summer. This brings the cartel’s combined production cuts to about 4.2 million bpd. The obvious goal of member countries is to shrink global supply and thus stem the plunge in oil prices. OPEC, which produces about one-third of the world’s oil supplies, normally moves the market with such announcements, but oil is down about five percent today.

OPEC member countries are losing money hand-over-fist as prices continue their free-fall. Furthermore, there is a substantial supply glut in the system, so much so that crude oil is being stored in tankers at sea because there is no place to deliver the product. Saudi Arabia, the largest oil producer in OPEC, is leading the way by lowering its oil production from 9.7 mbpd to 8.2 mbpd. However, Saudi Arabia does not have the massive financial and political pressures that Iran, Venezuela and non-OPEC member Russia have to contend with. All three of these nations need the barrel price of oil to be well north of $50 in order to sustain state budgets planned when oil prices were climbing. After oil’s dramatic collapse, these countries are operating in the red and will be greatly tempted to ignore OPEC-established quotas in order to generate desperately-needed cash. It is possible that a sustained drop in oil prices could threaten the stability of the Venezuelan, Iranian, and Russian governments.

According to CNBC, the previous two OPEC production cuts have only met with an estimated 50% compliance. Expect that ratio to continue to fall if oil prices continue to slide and budget shortfalls intensify. So, in essence, although OPEC member countries are all incentivized to pledge production cuts in the hopes of generating a turn-around in prices, each member country has its own circumstances and many of the poorer nations are simply not going to sit on their hands waiting for oil to rebound. OPEC’s chronic failure to enforce its production quotas makes them of dubious value.

Equitable ResourcesOne part of the supply chain that we can track fairly accurately are domestic oil companies, many of which are reigning in capital expenditures greatly. The rapid decline in oil prices has made many U.S. oil and natural gas producers scale back on projects, especially the largest and most expensive ventures. Combine collapsing oil prices with difficult credit markets, and there is very little incentive for producers to bring new reserves to market at the present time. Nearly every company has found that certain projects that looked profitable six months ago simply do not make financial sense with oil now between $40-$50 per barrel. The latest round of cut-backs comes from SandRidge Energy (SD) and Equitable Resources (EQT), which are cutting CapEx spending by 50% and 40% respectively. Hess Corp. (HES) has indicated that CapEx will fall by nearly 40% in the coming year. In addition, Devon Energy (DVN) is holding off on setting a budget for 2009 until it officially closes the books on 2008, not a bad move considering recent volatility.

Devon EnergyWhile it is unclear just how much the supply will contract, it is clear that OPEC would like it to contract as quickly as possible. Global demand has been extremely weak in recent months as a world-wide recession has taken hold. Modern economies run on oil and when economic activity begins to grow again, watch out for a spike in oil prices, as supply will be likely be tight. This will only exacerbate the roller coaster ride in oil prices that we have seen over the past few years.

One word of note, readers of our blog will recall a post from October 16th (Oil Stocks Are Cheap, But Will It Last?) describing the status of energy stocks as crude prices continued to drop. At the time oil had dropped exactly 50% from the high of $147 just a few months before, and I attempted to speculate as to where the floor in oil prices would be. I made the case that supply would be constrained by a further drop in prices from $74 as expensive production projects would be placed on hold, and that a drop substantially below $60 per barrel is not sustainable.

Well, let me say, that while a price this low may not be sustainable, I did not anticipate the steepness of the drop we have seen. However, my over-arching theory (as an equity analyst, not an energy analyst) was that oil stocks were due to rebound. And rebound they have, of the four stocks highlighted in that piece, only Transocean (RIG) is lower, dropping losing 18% since the post. RIG supplies deep-water drilling equipment and is especially susceptible to the declining price of crude. The big winner has been oil and natural gas producer Petrohawk (HK) which in two months time has gained 72%. Likewise the two major producers Exxon (XOM) and Chevron (CVX) have both gained more than 30% in that time.

RecessionSo, the fundamental question is when will economic growth recover? According to the NBER, the current recession began a year ago, and it is already the 4th longest recession in more than 80 years. We have included a helpful chart from the Wall Street Journal for reference. We firmly believe that this recession is not going to be another Great Depression, as some pundits and politicians would have you believe. The Fed and other central banks around the world have pledge to take all available actions to preclude this type of economic catastrophe. Yesterday, the Federal Reserve cuts its Fed Funds Target Rate to an historic low, .25%. While it is anyone’s guess as to how deep this recession will ultimately be, it is likely that the worst is behind us and economic activity could very well begin to grow within the next few quarters.

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