Profit From OPEC’s Mission Impossible

Sean Brodrick By Sean Brodrick,

Oil & Gas

OPEC may be pulling off the impossible. And by that, I mean getting a production cut agreement between prone-to-cheating members and non-OPEC producers to stick.

If so, it could change the ballgame in oil for 2017.

I’d give the new production agreement only about a 50-50 chance of success. But it’s worth keeping in mind. Because if OPEC can make this deal stick, oil could go to $60 or even $70 in 2017. And that could send leveraged producers catapulting higher.

So what’s the deal?

OPEC is promising to cut crude production by 1.2 million barrels per day (bpd).

Saudi Arabia is leading the charge. At first, that country said it would cut its production to 10.058 million bpd. Then, Energy Minister Khalid al-Falih declared his country will slash production below 10 million bpd if it needs to in order to make prices rise.

“I can tell you with extreme certainty, absolute certainty that effective January 1, we’re going to cut and cut substantially to below the level we have committed to on November 30,” Falih said at a press conference in Vienna.

Historically, about half of OPEC agreements fall apart. Most recently, the cartel made a deal with Russia in February, and it fell apart before the principals got home.

So what’s different this time? Importantly, the deal will be monitored by a five-country committee composed of Algeria, Kuwait, Venezuela, Oman and Russia.

But Russia isn’t in OPEC, right? RIGHT! This independent verification makes it harder for countries to cheat.

Here’s the other important change: Eleven non-OPEC producers, including Russia, have agreed to cut production by 558,000 bpd. Russia alone has agreed to cut 300,000 bpd.

The agreement starts in January and continues for six months.

There are differences of opinion on how much this will affect global oil markets. Interestingly, OPEC is one of the most pessimistic.

In its December “OPEC Monthly Oil Market Report,” the cartel said the agreement “will accelerate the reduction of global inventories and bring forward the rebalancing of the oil market to the second half of 2017.”

On the other hand, the International Energy Agency expects much more bullish results.

If these cuts stick – if – and if global demand grows as expected – if – then the IEA says global oil markets will move into deficit by the first half of 2017. That deficit would be 600,000 bpd.

And combined with higher demand, the IEA says overstuffed global oil inventories could dwindle at a rate of about 760,000 bpd in the first half of next year.

So that all sounds bullish for oil prices. But… there are some obstacles that oil bulls should be aware of.

The first obstacle is Iran. I told you here and here how Iran is a mortal enemy of Saudi Arabia. This rivalry has torpedoed previous agreements. This time around, Iran squeezed a concession from its rival: that it could raise its output 90,000 bpd to 3.797 million bpd. Iran has agreed to stop there.

But Iran, so far, has not submitted production data for November. This raises concerns that Iran could start cheating from the get-go. So we’ll see.

The second obstacle is the surplus of oil sitting in floating storage. Remember when oil prices crashed to the $30 per barrel range early this year? Prices would have gone even lower if traders hadn’t locked up more than 100 million barrels of oil in floating storage in tankers at sea.

Traders do this because future prices of oil are higher than near-term prices. So they can buy now and sell later. As near-term prices rise thanks to OPEC cuts, the incentive to store oil at sea goes away. And that could send an ocean of oil flooding into the market.

The final obstacle is increasing U.S. production. U.S. crude oil production averaged 9.4 million bpd in 2015. It has been falling, and the Energy Information Administration projects production will be 8.9 million bpd this year and about the same next year.

The IEA agreed with the EIA as recently as November. Now it has changed its mind. The IEA says rising oil prices will light a fire under activity in the U.S. shale basins.

The U.S. is not party to the production cut agreement between OPEC and other nations. So our oil companies can produce as much as they like.

The number of rigs drilling for oil reached 498 as of December 9, according to data from Baker Hughes. Not only was that the most since January, but it was the biggest single-week rise since July 2015.

Importantly, advances in technology allow modern rigs to do the work of four of the rigs that were common just a decade ago.

So yeah, the U.S. will produce more oil. And that may weigh on prices as well.

A Gusher of Profit Potential

The SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) has rallied hard over the past several months. I first recommended it on September 17. The next trading day, the ETF closed at $36.13.

I also recommended it on October 8. The next trading day, the fund closed at $39.11.

Recently, the fund traded at $42.10.

It is beating the pants off the S&P 500 at a time when the S&P is in a bull market.

The S&P 500 is up 6% in that period. The fund is up 16.6% – nearly triple the performance of the S&P 500.

And the momentum shows no sign of stopping.

This hot streak isn’t over yet. U.S. oil and gas production is going to crank into overdrive. Oil field services companies are going to do very well. And that has select investments priming the pump for more profits.

All the best,

Sean