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For months, oil market bulls breathlessly awaited an oil production freeze between major OPEC and non-OPEC producers.
This so-called freeze would have locked in output levels at record highs for major producers like Russia and Saudi Arabia. And both countries were already hinting at raising production even during the “freeze.”
Then last weekend’s Doha oil summit meeting in Qatar came and went with no agreed freeze. That didn’t surprise long-term observers of the oil market like me.
Yet the momo (momentum) investors partied on, pushing up oil prices. Why? And was it justified?
Temporary Disruptions
There are a couple reasons for the oil run, the first of which was legitimate.
There was a workers’ strike in Kuwait that took about 1.3 million barrels a day of production offline. Add to that disruptions in oil production in Iraq, Nigeria, Venezuela and the North Sea. That brought the total to roughly 3 million barrels a day that were offline.
The production disruptions put the supply-demand situation in the oil market into balance. But only temporarily.
The strike in Kuwait has been settled, kicking out one leg from under a continuing oil price rally.
Doha Was Doomed
Now, let’s get back to long-term realities. Why did Doha fail?
The failure came down to simple geopolitics. Bitter rivals Saudi Arabia (a predominantly Sunni Muslim country) and Iran (an overwhelmingly Shiite Muslim nation) continue jousting for power in both the oil market and the Middle East.
Iran had on numerous occasions told anyone that was listening that it had no intention to go along with a freeze until it got its oil output up to pre-sanction levels. That’s about 4 million barrels a day.
And again to anyone that was listening, the Saudis made it quite clear they would not hold back production and cede market share to Iran.
The “talk” was all a ploy to artificially boost oil prices. This was revealed in a letter from Qatar’s oil minister to Norway’s Petroleum Ministry. The letter said the freeze proposal “changed the sentiment of the oil market” and “put a floor under oil prices.”
Momo Psychology
The people running the oil-producing nations are seemingly quite aware of how Wall Street runs today – and how momentum trading is all the rage.
Fueled by freeze talks, the momo investors convinced themselves that the oil market is slowly rebalancing, and that balance will be reached within months.
To that effect, money managers (including hedge funds) are holding a near-record number of futures and options, betting on a higher oil price. Those bets could turn into oil-fueled fire in their portfolios that the famed oil-well firefighter Red Adair would not have been able to put out.
Meanwhile, the oil producers are laughing all the way to the bank and pocketing billions, despite oil fundamentals remaining terrible.
Fundamentals Stink
Demand is growing, but not rapidly. Meanwhile, supplies continue hitting the market.
Many of the nearly bankrupt U.S. shale producers have to keep pumping in order to stay alive. A good number of these firms have fracklogged wells.
Apparently, the momo investors have never heard of the term fracklogging. That’s when oil companies drill the well, but do not bring it online. The oil is left underground, waiting for higher prices.
Bloomberg reports there are approximately 4,000 fracklogged wells in the United States. Andrew Cosgrove of Bloomberg Intelligence estimates that if the fracklog backlog were reduced by a mere 170 wells a month, it would add roughly half a million barrels a day onto an already oversupplied market. Add to that the fact that many shale companies are hedging their future output like mad every time oil contracts dated in 2017 and 2018 get into the upper $40s.
This hedging will cap any price rally. I can’t think of a plainer signal that even the oil companies don’t believe in this rally.
Geopolitics
Then we come back to the geopolitics.
Saudi Arabia’s powerful deputy crown prince, Mohammed bin Salman, is not your father’s Saudi prince. He is only 30 years old and has basically been handed the keys to the Kingdom by his father, King Salman.
Mohammed bin Salman looks at the world totally differently than the prior rulers of Saudi Arabia. MbS, as he’s known, has signaled a big shift in Saudi oil policy. It is now part of their foreign policy.
The prince maintains a very hard-line policy on Iran. So until Iran agrees to a freeze or cut in its oil output, the Saudis will not accept any constraints on their production.
On the eve of the Doha meeting, Prince Mohammed warned that the Saudis could immediately increase their daily production by more than 1 million barrels, which would bring output to 11.5 million barrels a day. He further warned that production could be increased to 12.5 million barrels a day within six to nine months. He even spoke of investing into oil production to raise output to 20 million barrels a day by the end of the decade.
Take Your Profits
The momo investors were probably laughing at Prince Mohammed’s warnings, thinking it’s all a bluff.
But MbS is not the type of person that uses BS. He is quite serious. The Saudis are willing to flood the world with oil until its rivals – especially Iran and U.S. shale producers – are vanquished.
My advice to investors is to not get caught up in the momo euphoria. If you have profits in the shale patch in the past few months, take them. Their vast debt overhangs have not gone away.
Avoid direct plays on oil using derivatives too, such as the United States Oil Fund (NYSEArca: USO).
If you insist on having oil exposure, stick with the company with the best balance sheet: Exxon Mobil (NYSE: XOM).
Oil prices are not off to the races.
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