The Independent Investor: OPEC's Poker Game

The news this week that some OPEC members have at least agreed to talk, and possibly freeze production, had traders covering their oil shorts, sending crude up over 15 percent. But why should simply freezing production at multi-year levels stem oil's price decline?

Naysayers are right when they argue that holding production where it is does not solve the oversupply problem in world energy. At the present rate of production, an additional 330 million barrels of oil (or about 1 million barrels/day) of unneeded oil is flowing onto world markets.

That oversupply has been building for a year or more. It is being stored in spare oil tankers, storage tanks and wherever else suppliers can find to stockpile the stuff. And storage capacity is close to being filled, despite the winter weather in the U.S. At most, freezing production solidifies an extremely negative supply imbalance.

As usual, not all is what it seems when reading the headlines, especially when it comes to the politics of OPEC and the Middle East. Remember that up until now, OPEC's largest producer, Saudi Arabia, as well as Russia (the largest non-OPEC producer) have not even discussed global energy oversupply. The fact that they are now willing to talk and possibly freeze production could be an important first step in a possible solution to the firestorm of falling prices that has done damage to both countries and their finances.

Bears point to the fact that oil producers like Iran have no intention of freezing production. The global embargo on that country's energy exports, imposed over Iran's nuclear program, has only now been lifted. Prior to 2012, Iran's oil production amounted to about 2.5 million barrels a day. It now produces about 1.1 million a day. The country's government is dead set on regaining that lost one million barrel a day production as fast as it can. Energy experts believe it will take the country six to 12 months to achieve that goal.

It is here that the plot thickens. Let's, for the moment, believe that the big producers are serious about stopping oil's decline. Talk of freezing production might accomplish that on its own. However, boosting prices is going to require production cuts. Iran won't go for that and everyone knows that the Saudis and Iranians have larger problems than oil.

Syria has become a powder keg between these two opposing forces. Sunnis and Shiites are lining up for what could possibly be armed conflict in that country. If a deal could be worked out to both parties' satisfaction in energy, could that also be a first step in reducing tensions elsewhere?

How could this be accomplished? Since it will take Iran at least until the end of the year to rev up production, could Saudi Arabia persuade Iran to slow down its capacity drive for a few months in exchange for higher prices? The Saudi's, along with other nations, could cut production in exchange for a few, newly-found "production delays" by Iran.

For the world's energy producers a cut would only require each of the top producers to reduce their output by 100,000-200,000 barrels a day or so in order to balance global supply and demand. That could easily lift price levels to $40 or so per barrel. In that scenario, everyone wins.

Clearly, investors are praying for such a deal. The price of oil and the level of the stock market are connected at the hip, so where oil goes, so goes the stock markets. Any deal, however, is not going to happen in the short-term.

Given the extremely short time horizon of traders, I would expect that the oil price will fall again when a deal isn't announced this week. That is unrealistic, in my opinion, but if we do bounce off the lows again, I think my thesis and OPEC's poker game may have merit.

Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.