Wall Street Greek: OPEC's Actions Irrelevant for Now

By Markos N. Kaminis - Economy & Markets:

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Wednesday's highly anticipated OPEC announcement offered a relatively significant action from the consortium, but as crude oil prices moved curiously counter to intended direction, a question was raised. Was the action inadequate, or is OPEC no longer credible? We argue that the consortium has an even more serious problem than credibility. We believe that OPEC has in fact been rendered irrelevant, at least for now.

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Concluding its two-day meeting in Algeria, OPEC announced that beginning on January 1st, it would cut another 2.2 million barrels a day from its production quota. Taking into account two previously agreed upon reductions, the group slyly highlighted its 4.2 million barrel total cut of the past few months. Furthermore, following OPEC's request, and in an attempt to boost the price of crude, Russia and Azerbaijan also simultaneously reported planned cuts.

Since July's high of $147, the price of oil has steadily plummeted in correlation with deteriorating global economic data. OPEC has attempted to stop the bleeding several times through production action and announcements. However, its efforts have generated only little short-term disruption, and have had no lasting impact against the price slide.

At $40.50 on the WTI futures contract for January deliver, the price of crude oil at the hour of publishing on Wednesday marked a decline of 7.1% on the day. In fact, crude marked a four-year low on Wednesday, despite the OPEC announcement that would normally be considered very bullish. So what went haywire then?

The first few voices defining the situation pointed toward an inadequacy in the size of the production cut itself, as if to say a larger reduction would have helped or was expected by the market. This is to say that the news from OPEC was disappointing, despite the cut being the largest in its history. The argument, therefore, holds little water. However, this argument is genius in its simplicity, and we'll come back around to it before we conclude.

The Credibility Question

A group willing to look a little deeper into the quagmire might ask another question. Is OPEC still credible? Iran, Venezuela and others are notorious cheaters on their allotted quotas. These nations often call for rash action, but hardly ever follow through on their own part. In recent times, Saudi Arabia has even gone over and beyond its own quota to compensate for the failings of its cheating partners.

If there is no confidence in OPEC or in the sincerity of its members, then the price of the commodity should be expected to reflect skepticism. This argument holds water, but fails to accurately define the current situation, since production has in fact been reduced significantly. Even if the consortium partners only abide by say 75% of the cut, this action would still be significant.

OPEC has been Rendered Irrelevant

One might argue that OPEC's influence on market perception and oil price setting is materially changed since the '70s, and for good reason. The difference between that period and now is that resource scarcity has been exposed. In the '70s, we didn't seriously question the earth's supply. We viewed developed/undeveloped crude oil supply as abundant, and the suppliers as a valve and spigot.

When you fill your pitcher of water, you're only concern is turning the valve to allow flow-through. But what if you knew there were a limited supply of water in the reservoir, and that water flow could stop soon? Then, your concern would move from the spigot, which opens and closes as needed, to the reservoir.

We've come to expect OPEC to open and close the valve on demand. In other words, the market takes the oil supply valve fore granted at this point, and expects oil producing nations to supply the market. It's in their interest after all. If they do not, we understand that alternative energy options exist and that military force could be employed to secure supply. One way or another, the energy spigot gets bypassed or forced open. Therefore, we must ask, is OPEC really relevant over the long term?

The fundamental driver behind oil's price spike of the last few years was derived from a longer term perspective. We've come to realize that new oil field discovery and production cannot keep up with demand increase, which is driven by globalization and development of emerging markets. We have decided for the most part that the majority of the earth's petroleum resources have been largely identified. So it's the reservoir that limits us, and our focus is redirected from the spigot.

Therefore, whatever OPEC does is irrelevant. We know it's in their interest to develop their limited oil resources at a steady pace and at best price. That best price is at a point where it inspires exploration and development, but still keeps alternative energy options from economic feasibility.

While individual players can direct their exports, even Iran and Venezuela cannot afford to use oil as a weapon for an extended period of time. In limiting those exports, they would injure their own nation more than those intended for harm. To illustrate, the U.S. has the least direct risk to a disruption of Iranian supply, where Japan, China and India are most sensitive. Venezuela is another story though, and the alliance of Iran and Venezuela is therefore troubling to America.

Going to war for energy resources is possible, but highly unlikely, and if undertaken, costly and unpredictable. Besides, we're not going to war over a few dollars. It would take egregious constriction or malicious intent to put troops in the sand. At least come January 20th it will! Reiterating, the spigots are not as important as the reservoir; not even the rusty spigots.

As we focus on the scarce resource, we weigh global demand against global supply. As economic decimation is illustrated by record breaking readings of economic metrics, the market worries less about the reservoir, and so oil's precipitous price decline is derived. OPEC is irrelevant, therefore, but only for the theoretical and over the long-term perspective. Over the short term, and for the practical, OPEC could still prove critically relevant.

Show Me Mentality

OPEC is only irrelevant for as long as production cuts don't actually impact supply delivery. At some point, production cuts have actual impact though, and shortages occur. Once that happens, limited available supply should impact the price of oil, and even more so, the price of its distillates in heating oil, gasoline and even its substitute - natural gas.

A Moving Target

Each OPEC production cut acts against a moving target. Demand is still waning, and so, thus far, OPEC has not managed to meet lower demand. Wednesday's publishing of the Petroleum Status Report showed oil supplies climbed for the 11th week of the last 12. In fact, at 321.3 million barrels, U.S. crude oil inventories are near the upper limit of the average range for this time of year! Until OPEC's actions have a meaningful impact on local supplies, or if weather or unforeseen events impact supply or demand, then oil prices should continue to weaken. Still, soon enough, traders should start to think about those eventualities, and oil will mark bottom.