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OPEC Cutbacks: The Case Against Any Major Impact

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By John Richardson on 02-Dec-2016


By John Richardson

OPEC’s decision to cut production could well turn out to have no significant impact on the direction of oil markets in 2017 and beyond. I believe that everything still points to weaker, rather than stronger, crude prices, barring a major geopolitical crisis.

We are very likely heading for is a global recession in 2017 as a result of a stronger US dollar and high interest rates. Both will be the result of US plans for huge reflationary infrastructure spending.

The stronger dollar and higher borrowing costs will be awful news for the emerging market countries that have taken advantage of the post-Global Financial Crisis era of a very weak greenback and low interest rates.

Fifteen billion dollars has already been pulled out of Asian bonds and stocks over the last month –close to 30% of inflows to the region – since the US election results, according to Deutsche Bank. This will obviously get much worse when the US infrastructure spending actually begins.

Outstanding dollar-denominated credit to the rest of the world has more than doubled over the past 10 years to nearly $10 trillion, according to Societe Generale. Emerging market countries and corporations are responsible for $3.2 trillion of this borrowing, adds the French bank.

One has to always look at “trigger countries” in these situations. In 1997, the Asian Financial Crisis was triggered by Thailand and in this instance the trigger might be Turkey.

Russell Napier, in his Solid Ground investment report, argues that Turkey has $392 billion of foreign currency debt that has become much-harder to repay as a result of the sharp fall in the value of the local currency – the Lira. Reading the political mood, he assesses that if Turkey faces a debt crisis, it might well introduce exchange controls and default on its debt.

An emerging markets debt crisis that leads to a global recession would obviously drive oil prices lower. Hence, one very important reason why OPEC’s decision to cut production could well end up having no impact on oil prices beyond a short-term rally.

A stronger dollar of course also always leads to downward pressure on oil prices.

Another reason to expect weaker oil is the increasing efficiency of US shale-oil production. The extraordinary chart at the beginning of this post, from Reuters, further underlines the great leaps in US innovation that I have been discussing for the past two years. As Reuters writes:

In shale fields from Texas to North Dakota, production costs have roughly halved since 2014, when Saudi Arabia signalled an output free-for-all in an attempt to drive higher-cost shale producers out of the market.

Rather than killing the US shale industry, the ensuing two-year price war made shale a stronger rival, even in the current low-price environment.

In Dunn County, North Dakota, there are around 2,000 square miles where the cost to produce Bakken shale is $15 a barrel and falling, according to Lynn Helms, head of the state’s Department of Mineral Resources.

The US shale oil industry will thus be able to significantly increase production in response to the higher prices that have resulted from the OPEC production cut – and will, as a result, drive prices down again.

And next year we have the prospect of tax cuts and more relaxed environmental regulations that will allow the US oil industry to further increase production. This will be part of Mr Trump’s “America First Energy Plan” that promises to unlock $50 trillion of untapped oil and gas reserves.

Back to the global economy. The “Donald Trump is a businessman, and so a pragmatist” argument suggests that he will back away from a global trade war. My base case for 2017, however, remains a global trade war.

Mr Trump will, I think, have to live up to at least some of this election promises on trade. With China boxed into an economic corner as it struggles with its reform process, events could thus run out of control.

In a further indication of the risks ahead, Goldman Sachs banker Steven Mnuchin, who has been nominated by Mr Trump as Treasury Secretary, said earlier this week:  “If we determine that we need to label them [China] as a currency manipulator that’s something the Treasury would do.”

Meanwhile, despite the OPEC decision we are still obviously at – or close to – to Peak Demand Growth for oil.

The climate change argument is over as countries such as China also try to deal with very serious air, soil and water pollution problems.

The end of the Economic Supercycle also explains both today’s social, political and economic uncertainties (for example, the rise of Mr Trump) – and means that people have less money to spend on all the things made from oil.

The more that things change, the more they stay the same. Here again are our three scenarios for long-term oil prices from our study, Demand: The New Direction for Profit:

  1. $25/bbl oil = Collapsing demand – Emerging markets submerge, and developed markets slow dramatically as stimulus-created debt has to be repaid.
  2. $50/bbl oil = Comfortable middle – Stimulus policies prove to have worked, demand recovers, project cancelations and revived growth prospects create a balanced market.
  3. $100/bbl oil = Continuing tension – Economic recovery stalls as geo-political risk rises along with the potential for supply disruptions.

The “comfortable middle” isn’t going to happen. Barring geopolitics, therefore, we are still in a world of $25/bbl.