OPEC: Too Little, Too Late

In March of 1974, in the midst of the oil-dependent world’s first oil shock, economist and Nobel Laureate Milton Friedman noted:

Higher [oil] prices induced consumers to economize and other producers to step up output…In order to keep prices up, the Arabs would have to curtail their output to zero…Well before that point the cartel would collapse.

Jump ahead 24 years and we’re going through it all over again.

A few days ago OPEC’s president warned “severe” cuts were on their way.

“Severe!” The markets seemed shocked. What did “severe” mean? Oil prices went back on the climb. Many traders were thinking, “Maybe this time would really be different and OPEC’s members would all work together.”

Yesterday, we learned it was all for naught. “Severe” turned out to mean a mere 2.2 million barrels per day (bpd) cut.

Another record… the biggest production cut in the cartel’s history…but nothing like the 3 or 4 million bpd the market was expecting. As you might, oil prices collapsed 8% in practically no time and traded under $40 a barrel for the first time since 2004.

Race to the Bottom

Don’t get me wrong, a 2.2 million bpd cut is something. It just would’ve been something worth worrying about two months ago. Now, it’s a much different story. Combine steady declines in oil consumption around the world along with OPEC’s cheating ways (as a whole OPEC has produced between 1.5 and 2 million bpd over the agreed upon quota over the past few years – depending on the source), a 2.2 million bpd cut may not have any real impact on oil prices for a long time to come.

But here we are. Merrill Lynch recently predicted oil is going to $25 a barrel. Goldman Sachs (NYSE:GS), which has just called for $200 oil a few months ago, also predicted $25 a barrel.

It’s a tough time to be an oil investor. If you’ve held out and decided to ride out the storm (I wished you would have been a reader earlier) or if you’re looking to buy oil, there’s a lot of uncertainty.

Has oil finally hit bottom? Has the first half of a giant “V” formed in the oil price charts? How much capital investment will really be cut? How long will this window to get in on oil stay open?

As always, if you look beyond the headlines, there will be answers and we’ll be able to be certain when others are uncertain (which is usually a pretty profitable place to be when it comes to investing).

Oil in the Short-Term

Now, I don’t know where oil is going over the next few days or weeks. There are just too many variables. The trend is down and at this point not too many people are ruling out $30 or even $20 oil if the global economy takes another turn for the worse.

Here’s the thing though. The stock market is actually a very good predictor of oil prices. Oil service stocks (Oil Service HOLDRS ETF – OIH) tend to lead oil prices (U.S. Oil Trust – USO) for the past few years. When oil service stocks went up, oil prices have followed. When oil service stocks went down, oil prices followed.

As you can see in the chart below, oil service stocks have consistently led the way. Whichever way the OIH (gold line) went, USO (blue line) followed.


Take a look at September 2006, the OIH crossed above USO. Three months later oil prices followed suit.

Last summer the USO crossed over the OIH and oil prices started to get a bit out of control. Oil prices were running, but the oil service stocks weren’t going with them. Clearly there wasn’t much expectation in the markets for oil prices to stay at such lofty highs. Again, about three months after the crossover, oil prices started falling just like oil service stocks had been anticipating.

Now, oil and oil service stocks are at an impasse. If we see oil service stocks continue to climb, it’d be a safe bet oil prices will follow right along behind them in about three months time.

That’s why I suspect OPEC might get its wishes for oil prices to rise over the next few months. Whether OPEC’s cuts (or the OPEC members actually sticking to their quotas), an economic recovery, or something else altogether bumps up oil prices, a short-term run-up in oil prices is a very real possibility.

For my money though, I’ll keep an eye on the oil service stocks. They’ve proven over the past few years they’re much better at predicting the next move for oil than any OPEC leaders or analyst. Still though, OPEC always could be a factor.

Thinking Again

Time and time again, OPEC proves no one believes in them. After decades of cheating and failing to stick to agreed upon quotas, no one expects them to this time.

As we discussed a few weeks ago right after OPEC’s “pre-meeting” meeting, OPEC is “functional” at best when oil prices are high. When oil prices are low (and/or falling) the cartel just doesn’t work. In Oil’s Slippery Slope, we went as far as stating, “If you think OPEC is going to be able to keep oil prices propped up…think again.”

Now that oil prices have dropped another 20% since then (the drop would be closer to 30% if it weren’t for a 10% decline in the U.S. dollar over the same time period) we see how truly futile OPEC is against market forces. They can put on a great show and invite friends like Russia to the party, but OPEC can’t singlehandedly keep oil prices propped up.

Where to From Here

From here, oil has got a long way to go back to its previous highs. There’s a lot of extra capacity out there and it can be turned back on relatively quickly. OPEC has cut more than 4 million barrels per day of production, which will come quickly back online if oil prices rise.

But for those of us with a long-term outlook (5 years or more), there will be some good gains to be had in oil. The long-term picture hasn’t changed much and the big oil consumers of the world are still making moves.

China knows oil will be scarce once again and is continuing to secure oil reserves and production capacity. A few days ago China Petrochemical Corporation received government approval to move forward with its $1.5 billion takeover of Tanganyika Oil (TSX:TYK). The takeover will increase CNPC’s annual production by about 2%.

It doesn’t stop there. China is interested in offering $130 million for Urals Energy (LSE:UEN) according to Chinaknowledge.com. The deal, if completed for the price, would mark a 400% premium over Urals’ current market cap. Also, Canada’s Financial Post reported China National Petroleum has been sniffing around Verenex Energy (TSX:VNX) and could be in play as part of a $300 million deal.

It’s not just China getting ready, India’s right there too. India’s national oil companies (NOC) have set aside a total of $3 billion to secure new oil projects during the downturn. India is still upping the ante. The fast-growing nation has offered to build and pay for refineries and pipelines for prospective oilfields in Nigeria, Libya, and Turkey.

The Rich Get Richer

Clearly there’s still some interest in oil companies from interested parties. And from current levels, oil could realistically fall back to a $20 to $30 price range. After all, a lot of commodities have already reverted back to 2002 lows and its possible oil could fall right back there with them.

The distant future is bright in oil and it’s probably safe to start slowly wading into oil stocks again, but to go “all in” now could be a big mistake.

With OPEC still putting up a fight and oil traders willing to bid up oil in anticipation OPEC can actually work together, I still think that it just doesn’t feel like we’re at absolute, rock-bottom yet.

Oil certainly looks a lot better here than it did a month ago, but there are potentially much better opportunities in trading undervalued bonds or playing a convergence of the XAU/Gold ratio.

Still there could be an opportunity better than them all which we’ll go over in Saturday’s Prosperity Dispatch. You’re going to like this one. Until then.

By Andrew Mickey

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