I've written several times recently about the potential for OPEC to affect oil prices, since the 12-nation cartel controls an estimated 33% of world production.
Back in October I wrote about OPEC's decision to let weak prices continue, while yesterday I began to form the opinion that OPEC is trying to reduce prices and push higher cost producers out of the market.
My hunch that OPEC wouldn't cut production to support prices was correct, and the price of crude oil fell nearly 10% after the results of the meeting were announced to the world yesterday.
This doesn't bode well for Australia's producers, with shares in Woodside Petroleum Limited (ASX: WPL), Santos Ltd (ASX: STO) and Beach Energy Ltd (ASX: BPT) all declining substantially in today's trade.
Guesses behind the reasoning for the decision are three for a dollar, with The Fairfax media's coverage this morning listing a multitude of analyst opinions:
- Tariq Zahir at Tyche Capital Advisors New York felt that US crude could slide below $65 a barrel in coming weeks, a level which may challenge the economics of US shale production.
- Harry Tchilinguirian from BNP Paribas in London felt that 'Saudi Arabia and OPEC will have to live with a prolonged period of low prices for any dent in US shale or production levels to happen.'
- CEO of consulting firm PIRA Energy Group Garry Ross was quoted as saying: "Why would Saudi cut production in the current environment? Why would they want to support Iran, Russia or US shale producers? So they must have decided: let the market establish the price. Once the market goes to a new equilibrium, prices will go higher.'
Let's break these opinions down.
There is still an excess of supply in the market, which combined with negative sentiment could more likely than not drive prices lower.
Prices below $65 a barrel may challenge US oil producers, but BC Iron Limited (ASX: BCI) and Fortescue Metals Group Limited (ASX: FMG) are still in business despite very tough times in the iron ore sector. It's correct to say that low prices could put uneconomic companies out of business, but it doesn't happen very fast.
The third opinion may be the most insightful, but it also tells investors the least. Saudi Arabia has absolutely no reason to cut its oil production to benefit other nations, true, but this overlooks the fact that lower prices take a much bigger chunk out of revenue than is replaced by constant production.
Once the market moves to a new equilibrium prices will rise, true, but achieving a new equilibrium requires either increased demand or reduced supply or both; neither of which appear to be immediately forthcoming. It also overlooks the fact that the historical average price of oil is considerably below US$100 a barrel.
Why is it that analysts always look to Saudi Arabia and OPEC to control prices?
It's because they know that stock-exchange listed companies aren't going to.
OPEC controls 33% of the world's oil, sure, but this means that 67% of it is controlled elsewhere.
If anything listed companies might lift production in order to reduce their average costs per unit and improve their relative appeal (and share price, since directors are usually substantial holders) among their peers.
Oil companies are always trying to lift production, and OPEC's decision to let the market sort itself out might, worryingly, be just that.
The fact that the next meeting of OPEC isn't until 5 June next year, after having two in the past two months lends a lot of credence to the theory; light the world's oil markets on fire and come back seven months later to see what's left.
Investors can be thankful that Aussie producers are insulated from the worst by comparatively low costs and a weaker AUD, but things could certainly get worse before they get better.
