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This week the big news is the OPEC freeze deal. As those of you who regularly read The Five Star Standard probably know, I have been a big cynic of OPEC and any freeze. Even OPEC doesn’t trust OPEC: that’s why they don’t just use each countries production numbers, they use independent, third parties because they know that countries fudge their production numbers.
But for this deal, I have a slightly different take.
Obviously, the first major issue of any deal was reaching one. Great. They did. What I like about this deal is that Saudi Arabia, and its allies, are taking the lion’s share of the burden. As you may recall from earlier editions of our Newsletter, the big issue with OPEC has always been compliance. Every member has every incentive to cheat as long as other people cheat less (or the market isn’t harmed too much).
In this instance, Saudi Arabia has agreed to take the lion’s share of the production cuts (along with its Mid-East allies). While this is not unusual, the Saudis tend to adhere to their commitments on this front.
Saudi Arabia has even more incentive to comply this time around, and even some incentive to quietly cut its own production even further if other countries fudge. Their financial house is in disarray, their foreign currency reserves are shrinking, they are trying to radically rework their economy (they have a massive employment problem hitting in a few years if they do not diversify their economy to provide more jobs for their youth), and, more importantly, they are about to go through with the Aramco IPO – which means that their reserves will be valued according to their current value. So a $10 swing in oil to them isn’t about the $10.00 they will pump out of the ground today or tomorrow. Its about the 268 billion barrels (yes, billion) trapped under the ground. Multiply that by 10 and tell me what you get in dollars…. The more money their reserves are worth, the more money they will get for the sale of a portion of Aramco, and the more money they will have to keep the King in power (through keeping his subjects happy) and to rework their economy in accordance with their plan to invest tons of money in infrastructure, manufacturing, training, and education. Which, ultimately, makes for a more self-sufficient population, brings up their GDP, reduces their dependency on oil (which may not seem like that big of a deal now, but the Saudis see the writing on the wall – 30-50 years from now, when the next King is ready to take over, this could be tremendous).
Oddly, I think the danger comes not from OPEC but from the Americas. In another article this week, we reported that we are finally seeing signs of life in the American oil industry and we also reported that U.S. drilling costs have continued to decline. The rig count is up by 158 since May, sand prices are climbing, the newest, best, and most technologically sophisticated rigs are fetching $5,000.00 per day more than in May. Add to that oil service companies promising and just down right saying that they are going to demand more money for their services, and we see some recovery.
I think the only thing that scares me is that this accord is very delicate. Yes, the Saudis and their compatriots are taking enough of the share to bring equilibrium to the market sooner rather than later. Moreover, oil markets would have, in all likelihood, reached balance at some point in 2017 anyway. But to start diminishing worldwide stocks, it has to be more than that. My concern is the gold rush that could happen in America as drillers rush to bring production online.
Think about it. As we have reported, drilling costs in the U.S. have ben reduced substantially. Some of these cost reductions are temporary, but many are systemic and will survive regardless of whether a rig is more expensive. We reported earlier how Shell made huge efficiency gains that made their breakeven in basins like the Permian half of what they were. Reducing their checklist from 2000 to 200 is not going away – and thus, some of the cost reduction is here to stay. There is every incentive now for some drillers to rush in and gobble up rigs and enter into service contracts while they still have the upper hand and the leverage.
So while I want our industry to recover, I want it to be a sustained recovery. The best way for that to happen, is for the banks to keep a tight grip on the money, for drillers to be cautiously optimistic, and for service pricing to rise to a more sustainable level. Once all of that happens, I think we will have a sustained recovery that will allow oil markets to rebalance for several years, versus several months.
By: Ty Chapman
Five Star Metals, Inc.
Raising the Bar for Customer Service and Quality
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