RIP OPEC: 1960-2016




Summary

It's every country for itself now with OPEC.
The catalyst that brought an end to OPEC as we know it.
Original reason for the formation of OPEC no longer relevant.
Why this is good for oil.
source: CNN
For some time Saudi Arabia clearly stated it wasn't interested in attempting to influence the price of oil after the emergence of the U.S. shale industry. That resolve was tested when Venezuela attempted to leverage its relationship with Russia to press for a production freeze which would have helped push up the price of oil some. Passing the test, it revealed the fact Saudi Arabia was not only committed to the market rebalancing itself, but the reason for OPEC in the first place, was no longer relevant.
Back in 1960 when OPEC was founded, the impetus was primarily to form a cartel which could compete against large corporations, using its supply capacity to influence the price range of oil.
Now that the state-owned Saudi Aramco is preparing for an IPO of approximately 5 percent of the company, it is moving toward being one of those corporations it has been competing against for decades.
The implications for OPEC are staggering, in the sense it no longer has a real reason to exist, and with the Saudis taken steps in this direction, it's obvious it's looking out primarily for its own well being, however it may have an effect on OPEC members. Its ignoring of pleas from Venezuela confirms that's what we'll see going forward, as it struggles for its own survival in the midst of increased competition from U.S. shale producers, which has resulted in the price of oil plummeting and the revenue generated for Saudi Arabia shrinking.
OPEC grew in numbers and influence as more production was nationalized and companies owned by the states were created to produce oil and gas. The cartel was able to keep the price of oil in a desired range by setting quotas for each member, which helped keep the industry profitable. With the emergence of the powerhouse U.S. shale industry, that policy and strategy was no longer relevant or effective as a tool.
Even if Saudi Arabia wanted to keep the old methods in place, shale supply no longer allows it to. It has accepted that, and is taking steps to compete in an oil industry that has been totally disrupted from a player that will become the market leader within a few years.
Catalyst that brought down OPEC
Let me be clear on one thing: it doesn't matter whether or not OPEC as a legal entity remains in place - it no longer has a reason for existence. It is dead, and 2016 will be referred back to by historians as the end of the cartel's purpose for being.
What brought it down was the explosion of the U.S. shale industry, which quickly brought the U.S. oil industry into a top three market leader. It generated almost as much oil supply as Russia and Saudi Arabia, and will exceed them in the near future.
This matters because before U.S. shale, when OPEC decided to curtail or add to production, there were no competitors outside of Russia that was able to interfere with its decisions. Russia could have tried, but it has been producing at near to top capacity, and had little in the way of options to counter OPEC's will, even if it wanted to. The steadiness of the market and consistent profitability made it undesirable to buck the system in place.
That has all changed with shale, where the power to bring oil to a desired price range no longer exists. If OPEC were to cut back on production to drive up the price of oil, shale producers would simply boost production, which fairly quickly would bring oil prices back down. If it were to keep supply high, as it's been doing, it drives down the price of oil, reducing the revenue it was accustomed to have for its people.
Saudi Arabia and OPEC can no longer control the mid- and upper price points for oil, it can only have an impact on the low side of the price because of the increase in supply beyond demand. For that reason the Saudis have called for the market to rebalance, essentially because it has no choice. A number of high-cost OPEC producers didn't understand what the Saudis understood, which is why for a time they persistently called for a production freeze, with the ultimate goal of it leading to a production cut.
The Saudis resisted this because they knew all that would happen is OPEC would lose market share to its American competitors. This is where we are today.
This will only change when demand increases to supply levels, which with current production levels, will take time, contrary to the overly exuberant financial media, analysts and pundits, who are acting like we're on the verge of a rebalancing because of some temporary outages.
Reason for OPEC no longer exists
A lot of investors don't understand the importance of Saudi Aramco engaging in an IPO, even if it's only about a 5 percent stake being offered. To be a publicly traded company includes legal requirements it can't ignore, and that means it will operate much differently than it has in the past. It's a nod toward breaking away from OPEC - at least in its independence from the interests of OPEC members. Whether or not it remains a part of it as a legal entity no longer matters. Saudi Arabia, by its assertions and actions, has already broken away from its reliance and connection to OPEC in any meaningful way.
I say this because Saudi Aramco is moving toward becoming that which germinated the idea of OPEC in the first place - a powerful energy companies.
The new oil market means OPEC members must start thinking in terms of competing on an individual level and not as an entity. This is why Venezuela, in spite of its openly public pleas, is being allowed to descend into the chaos it now faces. That wouldn't have been allowed to happen even in the fairly recent past.
OPEC members weren't going to sacrifice the stability and loss of market share in their own countries in order to support countries that continued to run operations at very high costs. They have years to make improvements, and either didn't have the ability, or believed the price of oil would remain high enough to mitigate their high costs. They were wrong.
More than anything else, this is why there is in reality, no more OPEC. Individual members will increasingly make decisions based upon their own best interests. The weaker members will be forced to adapt or make significant improvements and changes to make their oil more competitive. Over time that would be good for oil.
Why this is good for oil
As a whole, this may seem a disaster for those that had depended upon OPEC in the past to use its influence to produce as stable and fairly stable oil market. But over time, this will bring about a stronger industry that will be driven more by demand and competition, rather than restraints on supply to control the price of oil.
I think we're going to see an oil market that becomes less nationalistic and more free. Those high-cost producers will be forced to make deals with companies that have taken a lot of costs out of production. There will also be an openness to offering larger stakes in national companies, as in the case of Russia, which has already increased the percentage of foreign ownership allowed in its publicly traded energy companies.
For that reason there will continue to be a lot of volatility and lack of visibility in the market, as it isn't something it has experienced for a long time; it could be said even as far back as the founding of OPEC, or even earlier.
When a market emerges that is increasingly driven by the self interests of competitors, it's actually much stronger than when it is attempted to be driven by a cartel like OPEC. It takes a disruption like that by U.S. shale producers to become evident.
Conclusion
With increased competition, companies will be forced to continue to reduce costs while increasing the productivity of wells. This will eventually lead to a lot more profitability for those companies finding ways to increase efficiencies. They will be the future winners, which is why Saudi Arabia is distancing itself from OPEC. It understands it can no longer prop up weak producers who have made little or no improvements for many years. The increase in shale production has brought all of this to the fore.
Saudi Arabia is showing the way for other OPEC members, with Iran playing a significant role as well. Its decision to produce as much oil as is best for the country - no matter what the motivation is - is another show of independence that will eventually spread through all of OPEC.
I don't know if OPEC will continue as a figurehead organization, which is really all it is now. But whether it does or not, its purpose for forming in 1960 is no longer there, and energy investors need to look at each country as a standalone producer. That is how it'll play out long into the future.

Source: Seeking Alpha