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OPEC & THe Commons Dilemma

2/17/2016

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"Anyone who ever gave you confidence, you owe them a lot." - Truman Compote, Breakfast at Tiffany's.

If confidence is the oil sector and the price of crude receiving a boost with a record high inventories and record low crude prices, that confidence may be owed to rumors of Russia coordinating a production cut with OPEC. ​It's ironic for market's to respond to this rumor. Russia is a major producer and OPEC is OPEC. Russia will never join OPEC for reasons I'm not going to get into here. This is an interesting development and telling signal of OPEC's strength.
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OPEC Members (2015)
POLITICAL BACKGROUND
Russia's relationship with OPEC has been one of distant animosity simply because OPEC = Saudi Arabia (SA).  During the Cold War, SA was a shadow enemy when the USSR invaded Afghanistan in sending money and fighters to the Mujahideen forces fighting the Soviets. Aside from that corrosive history SA have disliked each other by default due to SA being a strong ally of the US. 

US-Saudi relations go back to the oil shortages experienced by the Allies in World War I. This was in the hay-day of Britain's monopoly on Persian oil and France's ambitions in Iraq (Sykes-Picot Treaty). American companies were excluded from the region by the San Remo Petroleum Agreement of 1920 because WWII hadn't happened yet and every international oil company hated Standard Oil.

King Abdul-Aziz desperately needed money but also didn't want to jump in bed with a company operated by a country with Imperial ambitions, however the San Remo Petroleum agreement had him pinned with only the option of european companies. Due to money, several concessions were made to British and French exploration companies which yielded a string of dry holes.  Herbert Hoover made the "Open Door" policy happen and by the early 1930's a subsidary group of Standard Oil of California began drilling. They struck oil in 1938 in the legendary Dammam No. 7. Saudi Arabia completely nationalized it's oil fields as of 1980 but their relationship with the US has been historically been warm - the Saudi's have always viewed the US as having superior technical expertise (they didn't drill dozens of dry holes) and drilling technology and they appreciate their lack of imperialistic ambitions.  Until 1988, the name of the national oil company was known as the Arabian American Oil Co - changed to the current Saudi Aramco. To this day a majority of Aramco engineers are American expats.

COMMONS DILEMMA & OPEC
OPEC was every western countrie's worst nightmare from the 1970 - 1980's but over the last 20 years it has lost significance because of record high oil prices, it has fallen victim to the Commons Tragedy.  

The Commons Tragedy, described by Garrett Hardin in 1968, is an economic/social problem in which every individual tries to reap the greatest benefit from a given common resource. As the demand for the resource overwhelms the supply, every individual who consumes an additional unit directly harms others who can no longer enjoy the benefits. Generally, the resource of interest is easily available to all individuals. 

If the latter is to be believed, which I personally do, then OPEC cannot exist by the laws that govern human behavior in the same way sound cannot travel in a vacuum. Philosophically speaking OPEC's existence depends not on members more or less voluntarily abiding by the set quota, but rather a violation of a production quota causing swift negative repercussions. In other words OPEC is a failed not-idealistic-for-profit version of the UN. 

Smaller members consistently cheated on the quotas set by OPEC until Saudi Arabia tired of cutting production to support prices when member countries with governments in need of oil cash (Algeria, Venezuela etc. ) treated the quota with the reverence given to bathroom tissue. The latter would protest that SA shouldn't care, they have a lot more oil and a lot more money than anyone else - which happens to be true. Algeria hasn't thought to build a snow ski-resort in the middle of the desert because they had the cash to flip the bird to the efficiency of gigantic freezer operating in a climate of  100F+. 

It's not a question of who has a gold plated fleet of Lamborghinis and who has a country with 40%+ of it's population living below the poverty line. Altruism is not a force commonly found when a** ton of money is in play, but rather it is a billion dollar demo of the Commons Tragedy. 

OPEC can only function if (1) there exist a means of accurately metering oil production for all OPEC members to verify quota compliance (2) Meaningful disciplinary actions are implemented that are enforceable when quotas are exceeded.

Accurately monitoring oil production in OPEC member countries is all but impossible. Hundreds of thousands of barrels of crude can effortlessly disappear onto the black market, particularly in places such as Venezuela and Nigeria, where the government oversight is easily corrupted and organized crime thrives. Plus, not even unpaid interns will readily volunteer to jet off to Venezuela, a country were a BYO toilet paper is an important item on the pre-trip checklist and the expense report includes a line item "bribe funding". 

Statement (2) is not feasible because Saudi Arabia wields little real power over other OPEC members aside from it's immediate neighbors in the Gulf. The only weapon they have is, in the words of Sheik Zaki Yamani, "the oil sword". In this case, they're pumping the budgets of other OPEC members 6 feet under. Already weak petro-states lacking funds to provide social services and funding to their constituents face very real threats of collapse and, with the Arab Spring in recent memory, this is a rational fear.

This is further exacerbated by the fact that Saudi Arabia is unofficially the boss of OPEC but Iran is also an OPEC member. For reasons not explored here, Saudi Arabia and Iran really really do not get along. The Common's Tragedy phenomena is worsened by the fact that  SA will willingly singe it's own eyebrows if it means Iran losing it's beard. The same is true for Iran. The incentive for cooperation between 2 major members is severeley compromised and unlikely to improve. 

Because of all of these factors OPEC has become an elderly toothless tiger and rumors of meaningful production cut are only supported if Russia would team up with OPEC.  

PRODUCTION CUT
As of Tuesday (2/16/16), Saudi Arabia, Russia, Venezuela and Qatar* made a conditional agreement to cap their outputs at January 2016 levels in order to bring stability back to the oil market. According to several sources, Iran was pointedly left out of the meeting because (a) if they had invited Iran, the Saudi's wouldn't have showed up and (b) the Saudi's run OPEC so Iran wasn't invited. However, according to the rules of OPEC, they must make a production cut. Iran has so far expressed tacit support but at the same time they are not willing to cede market share. The meeting involved each other so neither is particularly happy. 

*Qatar's oil production has upped over the last year but it is still a is relatively small contributing member of OPEC.

The announcements of the latter to freeze production levels at January 2016 levels has pushed oil and stock prices up. There are both a bull and a bear interpretation of this event with equal levels of uncertainty. No matter how much oil companies are praying that oil prices rise once more, the proposed cuts are not nearly aggressive enough to support an immediate price recovery, it is Irrational Enthusiasm. January 2016 production levels for OPEC were record highs with Iran at over 3 mbpd and Saudi Arabia and Russia at 10.2 and 10.5 mpbd respectively. 

Iran has to agree - because there is no way in hell SA will give up market share to Iran - and that probability is not extremely high. Iran has already lost significant market share during the economic sanctions just recently lifted hence they see themselves as being pushed further into a corner. 

Russia may be in desperate need of oil revenues but has very practical reasons for not making production cuts. The vast majority of Russia's Oil is from Siberia and sub-arctic locations. In the desert of Saudi Arabia with an air temperature average 90F, oil wells may be turned on and off with ease. In Siberia where air temperatures are below freezing, to shut in a production wells and pipelines is to forever surrender them to the cold. Alaskan's and anyone who has had to cold start a diesel engine at -40F will understand.

This thermodynamic truth is basis of why Russia will never be a swing producer or an OPEC member. Their agreement to freeze levels is simply to not bring any new wells online. Russia's oil producers have an upside down economic world: economic sanctions on Russia devalued the ruble greatly which made capital investments into new developments very cheap hence Russian oil production kicking up to a post-Soviet record through 2015 and into 2016. The second Russian Oil Miracle. 

Russia has the capacity to up production to over 12 mbpd through 2016, this fear of the Russians coming with still more oil would be nightmare for OPEC. Hence the if the production cap agreement holds, it truly will be a miracle on oil.

ZEITGEIST
It is my observation that everyone from the meekest OPEC member to the most bullish oil trader is possessed by the same Zeitgeist: believing that $100+ oil prices are just around the next bend. This Zeitgeist is rewarded and popular from Wall Street analyst and oil company CEO's opinions to  financial magazines to oil & gas publications.

​It is the same that is the deadly wound to OPEC: all of it's members are betting on oil going back up, they have tasted what $100 oil revenue looks like and therefore refuse to cede market share because when the price goes up, they will be set to make a killing - hence the feedback loop of the commons tragedy and OPEC's current position as the toothless elderly tiger.

This zeitgeist nothing new, the behavior of companies after prices crash in 1986 was very much the same the difference being that a 16 year price slump very effectively removed all optimism for a rebound. Circa 2008, I believe Peak Oil added to this common mass conversion that easy oil was gone and therefore low oil prices were a thing  past. Period. Hence many are convinced that a price rebound is just around the next bend. Personally, I see this slump going on for at least 2 more years, possibly into 2020. 

NOW WHAT?
Saudi Arabia and most of OPEC won't make meaningful production cuts and Russia's ability is limited. The world is drowning in oil, outside the occurrence of a force majeure, it will take several years for the excess oil in the market to be absorbed and then and only then will prices once more rise. 


2016 is the year of Bipolar markets, first we thought interest rates would rise, then they held steady as the Fed observed interest rates going into negative territory in Switzerland, Sweden and Japan. We thought oil would rise and now West Texas Intermediate crude is looking towards the $25 dollar mark. Once capital investments are sharply cut by companies there is phase lag between oil production dropping, excess being absorbed and prices once more rising. But that phase lag is years in the making. This upward move in the market is a perfect illustration of the "irrational enthusiasm"  that begets the behavior of investors, sheep and lemming.

A world drowning in oil, a world gone mad. 

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    I grew up with fire, ice and North Slope Crude in my veins. I completed a B.S. in Petroleum Engineering and currently work as a wireline field engineer in the Permian.

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