Previewing OPEC’s Latest Confab

All eyes in the oil market are on OPEC’s upcoming meeting. But whether the cartel finally makes good on its long-awaited promise to cut production or not, we counsel taking a longer view on prices.

Production Cuts: Are We There Yet?

The Organization of the Petroleum Exporting Countries has been disappointing oil bulls for two years now. In fact, it was just about two years ago, when the group shocked markets by publicly opting not to cut production despite weak crude prices, that oil’s rout began in earnest. Traders seemed flummoxed that OPEC was abandoning its long-standing role as the unofficial regulator of global oil supply at a time when U.S. crude output was soaring and the world was awash in excess oil.

Over the last two years, the oil market has rallied repeatedly on rumors that OPEC was finally going to rein in its output to bring supply and demand into better balance and prop up prices. So far, all of those rallies have fizzled as OPEC failed to follow up rumors of a production cut with concrete action.

Could the OPEC meeting next week finally deliver and give oil prices the boost that bulls have been seeking? I remain skeptical, for two reasons. First, there’s the simple “Charlie Brown and Lucy” factor. How many times does OPEC have to pull away the proverbial football before traders realize they’re being played for fools? Or, to use an old stock market adage: “The trend is your friend.” For two years now, the trend has been for OPEC to overpromise and underdeliver.

Second, OPEC seems stuck between a rock and a hard place. No individual OPEC member wants to export fewer barrels, unless the group can jointly cut enough to push prices up significantly. No one will squawk about a 5% cutback in exports if it results in a 10% price increase, for instance. But how much confidence can OPEC members have that they can engineer a price pop big enough to make up for exporting less? Especially in a world in which U.S. energy companies can quickly put more rigs to work in places such as the Permian Basin in Texas when oil prices rise?

That’s not an academic question. The latest weekly reports from oilfield services company Baker Hughes show that U.S. drilling is already picking up, with much of it targeting the Permian because of its abundant resources and relatively low production costs. The U.S. Geological Survey just issued an estimate showing that one formation in the Permian, the Wolfcamp Shale, holds 20 billion barrels of technically recoverable oil. That’s three times the size of North Dakota’s prolific Bakken Shale. And as we wrote recently, shale operators are growing increasingly efficient at getting more oil out of each well they drill while also cutting costs.

Combine an OPEC-sparked oil price rally with this leaner, meaner cost structure, turn it loose on a massive oil play, and you can pretty much bet that American oil output would soon be humming. Indeed, the latest reports from the Department of Energy show that production is already creeping up after a year-long slide. Surely OPEC knows all of this.

When the Dust Settles

I expect plenty of volatility in oil markets after the OPEC meeting next week, no matter what the cartel decides to do. An announcement of a deal to cut production would engender a quick price rally, likely pushing West Texas Intermediate above $50 per barrel. Failure to reach an agreement would probably see prices plunge to $40 or lower. Something in between, such as an announcement of a temporary cut or a smaller cut than markets had expected, could send the price of crude up, down and up again with little net change.

But the longer term is what matters for businesses and investors. And our long-run view remains the same: Oil prices will gradually grind higher next year, averaging somewhere in the low $50s per barrel, versus today’s high $40s. World oil demand figures to keep growing at a modest pace, and many large drilling projects around the globe have been canceled recently because they aren’t economical at today’s oil prices. U.S. output should increase thanks to its increasingly productive shale oil fields. But production elsewhere stands to suffer because of the pullback in ventures such as deep-water wells and offshore drilling in Arctic waters.

That sort of gradual price gain is no doubt less than what oil companies and the petro states of OPEC would like to see. But it’s probably the world they’ll have to live with for some time to come.