OPEC: Lemonade Cartel

Oil was up today as word is that OPEC may do something about the production overrun. As I mentioned in an earlier post, this sounds very nice, but, much like a kid with a lemonade stand and no customers, the markers come out and prices keep dropping until they finally have to pour it all down the drain.

“Come on Phil!” you may say, “Surely the Organization of Petroleum Exporting Countries is more sophisticated than a couple of children selling lemonade at the side of the road.”

Sadly no. They are not. In fact, it could be argued that they are in a poorer business position than your average 8 year-old because:

A) The 8 year-old doesn’t keep making lemonade even when no one is buying.
B) The 8 year-old knows how to price to the market. When business is slow, they immediately drop prices to keep the consumers in the game.
C) The 8 year old isn’t funding a $60b dollar economy almost entirely on petro dollars!

According to Richard Bernner of Morgan Stanley: “Higher prices ultimately beget more supply and trigger conservation. And commodity demand tends to shrink as a share of output as economies mature and likely become more service-oriented.” In other words, while demand may be inelastic in the short run (say the past 2 years), over the longer term the supply and demand curves invert, and they are just as slow to move back the other way.

The greed of oil countries (who could have talked down prices before demand snapped) and oil traders literally drove prices to the breaking point: the point at which U.S. consumers actually stopped buying SUVs!

Now 30% less SUVs over 3 years means 9 million cars that will get at least 5 miles more per gallon, consuming 40m less barrels of oil per year. That’s assuming no one is car pooling or shortening trips in any other way. As we previously mentioned, just 1 degree on the thermostat drops another 1-2% off energy consumption, and you just know industrial users (including airlines) are cutting back, so we could be talking about knocking close to 1m barrels a day off U.S. consumption.

Will OPEC fold up their lemonade stand? Of course not! We still use 20m barrels of oil per day, and 9m barrels are produced at home. Rig count is up 20% in the continental U.S. and, if that leads to a 20% increase in domestic production, that’s another 1mbd that we won’t be buying from OPEC.

What’s an oil cartel to do?

A production cutback can work if demand is inelastic (it isn’t), but what happens when supply is inelastic? It isn’t the U.S. that’s addicted to oil, it’s OPEC that is addicted to cash, and we have them Jonesing big-time for a steady fix.

Oil is not a finished product. It is a raw material that has no value to the producer if it sits in the ground. Every barrel that goes unsold is an opportunity cost. Our cash is their principal source of OPEC income, and it will be a hard sell to get their members to turn off the spigots.

Iran, for example, exports 2m barrels of oil per day, taking in $47.5b a year in revenue at $65 a barrel.

When oil drops to $60 a barrel, Iran’s revenues drop down to $43.8b a year.

A production cutback of 10% of OPEC’s 30b output to maintain that $60, if it were spread evenly, would cost Iran an additional $4.4b (and idle production facilities, putting people out of work, not to mention infighting among groups as to who shuts down how much production).

This would drive their net revenues down to $39.4b, a 17% decrease!

Let’s not forget that there are production costs there as well. If we assume production accounts for $20 of every barrel, then we are talking about a much steeper decline in net revenues…

If instead, Iran were to continue producing a full 2b and let the price drop to $55 they would net $40.15b, more than if they cut back. Of course if they cheat and scale up supply, they could even come out ahead –- but that would be wrong!

Once oil gets down to $50 a barrel or less and Iran is out over $14b a year in revenues, cutbacks will be the furthest thing from their minds!

Another problem with production cutbacks is that OPEC simply isn’t the only game in town anymore. Aside from our (and the rest of the world’s) growing use of domestic fuel sources, non-OPEC countries now produce 65% more oil than OPEC does. Not many of those countries (we are one of the biggest) have much interest in maintaining OPEC’s price floors.

Oh no! Another lemonade stand opened across the street! We all know what happens when the customers are scarce and the kids have to compete for business...

Comments

[RogerMetzler]

YOur math is questionable at best

[Saul Sterman]

I love lemonade!

[VladimirSenkov]

Your thoughts are entertaining. However, everything that you said about supply/demand situation in commodities is obvious and has always been so. What has changed. You said "demand has snapped" and then started signing all happy.
I'm glad your positions are doing fine. But don't get ahead of yourself.
Fundamentals have not changed and demand will eventually come back.
Just as US consumers stopped bying SUVs at >$3/gallon they will jump right back on those beasts at 2$/gallon. It is generally much easier to increase energy use / gain weight as compared to losing weight / conserving energy.

I think the real reason for recent drop in oil and natural gas is mostly due to absence of hurricanes this season, not due majic demand snap, OPEC stupidity, trader greed, increase in production levels or some magic price level that was reached and caused significant conservation etc, etc as those things have all been there for some time and somehow were not contibuting much to oil price movements.

[LennyZephirin]

Yes your math is questionable! Look like you are mixing coffee with lemon. Iran produced approximately 3.75 - 4MM/bbl. Iraq produced approximately 2MM/bbl. OPEC's revenue is based on its own price basket not current WTI Prices or an average?. OPEC (including Iraq) is currently producing approximately 29.890MM/bbl as of the latest data. That is approximately 1.3% lower than what was produced two years ago - 30.280MM/bbl. The proposed quota is approximately 28.000MM/bbl and a production cut is neutral to the market.

And is not just another lemonade stand as oil from the Middle East cost less to refine versus from other region. Also, keep in mind that oil is a by-product and frankly, has nothing to do with how much SUV's we purchased!

FYI Iran is expected to earn approximately $49.2 Bil. this year and only a slight increase from 2005 of $46.6 Bil.

The issue is not OPEC is simply traders making the wrong bet.

[Philip Davis]

Len,

Appreciate the input - it's an article, not a master's thesis so I average things like oil at $65 and 2M, rather than whatever the actual numbers are. Still, I'm happy to see it's right in the ballpark but I don't think you should be comparing 2006 to 2005, when oil averaged $58, but to 2004, when oil averaged less than $30.

Of course I wasn't talking about how much Iran produces, but what it exports, which is actually about 2.5M barrels - this is a widely held misconception about Iran's power in the market. The 2M number was just a convenient example as I didn't want to just say "Sample country A". The math, questionable though it may be, applies to any model.

Iran's specific problem (and the real reason they want nukes) is that their internal use of energy is eating into what they can export:

www.energybulletin.net...

The less to refine arguement works when oil makes up 20-30% of the cost of refined product but at 60% of the cost - you'll find people will chose the "less tasty lemonade" to save a few bucks.

I agree that a lot of OPEC is traders taking the wrong bet as the fact of the matter is that oil is certainly not worth $60 or even $40 a barrel. I have written numerous other articles on the evils of traders, now it is OPEC's turn because the traders will move on to pump and dump another sector but it's the OPEC countries that will be left with all the warm lemonade.

[LennyZephirin]

Phil,

We had a good conversation going. You point out that Iran oil export is eating into its own energy usage, which is correct—However, your conclusion to personally assume the reason to harbor nuclear energy is out of context. And is not Iran specific problems. All oil producing countries had these problems and those who have not yet, will have it, sooner then later. Most would argue that isn't the same reason why the US builds nuclear plants (alternative energy usage) as the population was eating into its own internal oil production? The simple answer is YES. Even that is not enough as the growth of population and the diminishing of oil wells in the US was more than evidence for the US to import oils and will continue to import oils.

[Philip Davis]

No disagreement there. I think it is ridiculous for us to try to stop people from having a power source that we enjoy ourselves. Axis of evil or not, what right do we have to tell them they can't have technology available to our allies.

We need to conserve and innovate, clean up our own house before trying to push our will on others.

[CrossProfit]

This cryptic message is for Phil.

Saul says (Simon says) “I still love lemonade. I drink and drink and drink until my belly is full. By Friday I will be overloaded. On Monday I will definitely need to take a leak. Then I’ll see if I want to start all over again.”
XOM, COP, CVX

(You know I don’t play options but that doesn’t mean that I don’t appreciate your investment style. Good luck and I hope you use this well. By the way, there is intriguing new funding (29M) at AIRN. Have you noticed the [low volume] play?)

Disclosure: Comment by Saul Sterman, reflecting the opinion of CrossProfit.com. Unless explicitly stated otherwise there are no conflict of interests. Members and associates of CrossProfit and their immediate families are long AIRN as of 9/27/06 and create a conflict of interest.
www.crossprofit.com