POV on Effects of OPEC's New Price-Band Mechanism.
We believe that OPEC's new price-band mechanism, should it succeed, is extremely favorable for the entire oil sector.
Background:
After a two-year bear market triggered primarily by the 1997 Asian crisis, crude oil prices have rebounded from a low of under $11/Bbl. recorded in early 1999 to the $30-ish level today, heights that have not been witnessed since the gulf war. The rise in crude oil prices since the early 1999 low point has been swift and impressive, with nary a single quarter of significant weakness. The catalyst for the surge off of those lows was an OPEC production cut of significant size. The infamous cartel, known for their constant bickering and dis-cooperation with eachother, have managed to put aside their quarrels for over a year now in a manipulative effort to coordinate a more favorable supply/demand balance in the oil market. Their surprising level of teamwork has correctly caused the world to accept that OPEC is once again in firm control of the price of crude.
Amid strong backlash and crafty political maneuvering by certain shameless government officials, who of course are working for their own political gain, and in the face of public outcry over rising gasoline and heating oil prices, OPEC's U.S.-friendly members, namely Saudi Arabia and Kuwait, have been trying to push the cartel to increase production by an amount that would be sufficient enough to drive crude prices back into the low-to-mid $20 range. Other cartel members, such as Iran, Libya, Indonesia and Venezuela, do not want prices to return to the mid-$20 range and have expressed this view quite strongly.
Several facts need to be mentioned here. First, any crude pumped from the ground and sold at a market price of greater than $20 generates huge profits for even the most inefficient producing nations and for the oil companies themselves. Second, Iran, Indonesia and Venezuela are all recovering from vicious depressions that hit their countries from 1997 – 1999, especially Venezuela, which is the #3 producer, and the #1 supplier to North America – so they really need the flood of cash they are getting at current prices just to get their economies back on track. Third, since a June 21st 500,000/Bbl. (barrels) per day production hike, Iran is producing at 100% capacity, and all other OPEC nations are now at over 95% capacity –except our two Gulf War friends. Saudi Arabia and Kuwait are each producing at 86% and 92% capacity, respectively. Non-OPEC members, which include Russia, Mexico and Norway, are at 100%, 95% and 95%, respectively. Non-OPEC members generally go along with the views of OPEC, so their lack of membership is insignificant to their power over crude oil prices. The U.S. and Canada, also non-OPEC members, are insignificant and moderately significant producers, respectively, with little power to manipulate market prices through domestic production adjustments.
The Price-Band Mechanism
At an OPEC meeting in early spring, held to increase production amid U.S. pressure (or begging), the cartel came up with what we believe is a brilliant idea – a concrete plan to keep prices within a price-band of $22 - $28. Under the price-band mechanism's guidelines, OPEC will automatically decrease production by 500,000/Bbl. per day should the average price of a basket of different heavy & light crude grades fall below $22 for a 20-day period, and, conversely, OPEC will automatically increase production by 500,000/Bbl. per day should the average price of the basket trade above $28 for a 20-day period. Should OPEC manage to successfully keep prices in the band through this crafty manipulation of the supply/demand balance, they will once again have complete control over oil prices as they had back in the early 1980's. If anyone cares, the basket is based on the average market prices of Algerian Sahara Blend, Indonesia Minas, Nigerian Bonny Light, Saudi Arabian Arab Light, Dubai Fateh, Venezuelan Tia Juana Light, and Mexican Isthmus.
The cartel held an emergency meeting on June 21st because the basket, the price of which is always a couple of bucks less than WTI (West Texas Intermediate) crude prices, traded above $28 for a 20-day period, triggering a 500,000/Bbl. per day OPEC production increase. Prices were so strong that the cartel was pressured to hike production by 1,000,000/Bbl. per day, but they once again surprised everyone by keeping their poise and increasing production by the band minimum (the actual hike was 708,000/Bbl. per day but the 208,000 difference is recorded to account for minor OPEC quota 'cheating,' which is always factored into the market price, so this was not unexpected). Anyway, to get back to the original point, OPEC's bold action has served as a two-fold lesson. One, OPEC has continued to work as a team and there is little discord amongst the members as was the case just a few years ago. And two, OPEC has shown the world that the price-band mechanism is for real, which is an extremely important development because if the market does not learn to respect the much-ridiculed band then the band will soon become a sideshow.
Earlier this week (week of 7/21), Saudi Arabia was yammering about how it was just seconds from increasing production all by itself by a full 500,000 Bbl. per day because the June output hike had little, if any, quelling effect on prices. In fact, prices had continued to trade just above the price-band's maximum. However, now it appears as if no hike will take place because their vocal threats have since worked to 'talk down' the market price by a couple of bucks over the last few days. Incredibly, the crude basket average traded below $28 for a single day – averaging $27.72 on Wednesday 7/19, an event which has had the effect of triggering a restart of the 20-day price-band mechanism average. We start counting to 20 all over again! The OPEC plan is working!
What This All Means For The Oil Companies
Should it prove successful, OPEC's price-band mechanism will go down in history as the greatest financial market manipulation device of all time. Assuming this occurs, the band will, without a doubt, beneficially change the future profit picture for the oil industry indefinitely. With the band minimum set at $22, oil companies are being promised a non-stop bonanza, as $22 oil is quite a profitable level. Already the global market is starting to realize that the price-band mechanism is for real, as crude oil futures prices all the way out to 2005 are trading near the band minimum, as current, or 'spot' crude prices, all in the high $20's, descend down to the band minimum the further out on the calendar you look. This phenomenon is known as 'backwardation' and is quite common for prices when a particular commodity has risen very sharply in a short span.
The Money Tree
This is all working to serve as a money tree for the oil companies. Right now, with prices at the top of the price-band's range, oil companies are probably selling forward significant portions of their annual production, locking in tremendous profits. All major oil companies' costs of finding and producing a Bbl. of crude are well under $10. Considering that these companies all managed to eek out minimal cash profits when oil was trading in the low-teens, you can well imagine the tidy sums that are accumulating on their balance sheets at present, even if they sell forward at price-band minimums! Furthermore, the price of crude is presently unlikely to plunge to the bottom of the band as a result of the heavy spot & forward selling, because their is just as much heavy spot & forward buying by the refiners. The refiners are already running at over 95% capacity in an effort to keep up with the extraordinary demand. World growth is exploding as economy after economy breaks out of the shackles of '97 & '98's global mini-recession, so demand is likely to continue to accelerate for a considerable period. The refiners simply can't keep up with the demand – and because the demand is so great, the refiners themselves are making a fortune (finally!). By the way, their excuse for today's high gasoline prices - that they need to cover the cost of adding new government-mandated air-friendly chemicals to the final product, is just that – an excuse. The refiners are simply making up for heavy losses suffered during the preceding two years. The oil companies themselves will now work to grow profits by increasing production – and the only way to do that is to spend more on exploration, which will in turn benefit the drillers and E&P companies. Additionally, technological innovation is constantly reducing the cost of finding and producing a Bbl., so that is another profit driver. Any which way you look at it, you have to be bullish on the entire sector!
A Few Words On Gasoline & Heating Oil Prices
Stop your bitching, America! Do some math. Crude has tripled off of its lows. A gallon of gas has only doubled. A gallon of heating oil has not nearly tripled, either. Considering that the real pain lies ahead, current prices should be enjoyed, not scorned. And we should all become comfortable with current prices because gas will probably never be available for under $1.25 ever again. That price area has simply been left in the dust. Maybe today's supposedly high prices will make us all appreciate oil a bit more from now on. After all, in mid-1998, in what must have been the biggest buy-sign for oil of all time, one witnessed that a 1-liter bottle of Evian was more expensive than a gallon of gas. Consider this: everything we have we have because of oil – from the gas in your car, the shirt on your back, the food in your stomach and the computer on your desk – none of it would be possible without oil. Yes, black gold is involved in the designing, manufacturing and/or shipping process of just about anything you can think of. Something that important should be worth at least $30 a barrel.
-LB Capital
lbcapital.ckt1.com |
