OPEC's Dirty Little Secret

Jim Brown
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OPEC members will meet in Vienna on the 14th to discuss production targets. With oil prices in the low $80s there is not likely to be any change in quotas. The real secret is that it would not matter.

OPEC cut production by more than four million barrels in 2008 and even though they are cheating on those quotas crude prices are at the upper end of their target range. This suggests several key factors are in play.

The compliance with the 4.2 million barrel per day cut in December 2008 is currently at 57%. That means current production cuts are roughly 1.9 mbpd rather than the 4.2 mbpd face value OPEC maintains. This is actually higher than a few months back when compliance fell to 53%.

We are nearing two full years under this headline number and oil continues to creep higher despite high inventory levels. Every analyst and hedge fund knows full well that the 4.2 mbpd cut is a sham and with prices this high there will be further cheating and compliance is expected to decline again once the meeting is over.

Bloomberg claims OPEC production from all 12 nations in September averaged 29.1 mbpd. That was down from the 29.3 mbpd average for Q3. That is expected to decline even further to 28.6 mbpd in the first quarter of 2011. OPEC production is slowing even with $82 oil prices. Even with the cheating production is declining. Why?

Something is seriously wrong with the current oil market and the rise in prices.

The U.S. demand fell -6.5% to 18.5 mbpd last week in what can only be described as weakening demand in the world's largest consumer. Refined product inventories in the U.S. are at 20-year highs. Oil prices should be declining rather than rising.

Obviously the dollar is a major factor in the price increase. The dollar has declined nearly -10% in the last three months and gets a lot of credit when oil prices rise. Personally I think the credit is overdone and we are seeing a different factor at work in the market. The dollar's decline may be a supporting factor but there is a bigger picture even though much of that picture may be hidden from the public.

The IEA is projecting limited demand growth in 2011. They believe China's demand will rise only 4.3% and Europe will decline by 0.8%. China's GDP is expected to grow 8.9%, India 8.3%, Argentina 8.4% and so on but for some reason the demand expectations are lagging.

The IEA is scheduled to release its next demand estimate on Oct 13th and one day before the OPEC meeting. Saudi's oil minister believes oil prices are higher due to speculation. That is always their answer whenever questioned about the rise in prices. It is never a shortage of oil or a bad product mix. It is always speculation.

This time they may be right. The CFTC Commitments of Traders report last week showed that hedge funds and large speculators increased long positions by 44% to the highest level since April 23rd. Why? Why did hedge funds suddenly decide it was necessary to boost positions by nearly 50%?

Was it the additional stimulus by the Fed that is expected to be announced the day after the elections? If the Fed goes for QE2 or QE Lite as some are calling it the value of the dollar will decline again. However, the dollar is at support at 77 on the dollar index and very close to two-year support at 75. How much more can it fall? Even if it did fall to 75 over the next six weeks what would that do to oil prices? A drop to 75 would only be 2.6%. In theory that would increase the price of oil by $2 assuming there were no other factors. Since there is no exact correlation between dollar value and oil prices it may only add $1 and not $2. It could add even more than $2 on short covering but the answer is we don't know how much would be gained. Even if they could be assured a $2 profit does that justify an increase in long by 44%?

There has to be something else in the equation. I believe it is the camel's nose under the tent. It is the dirty secret OPEC does not want you to know but hedge funds have figured out.

I believe the combination of increased demand inside OPEC and the product mix is coming together to create a shortage of light crude. There may be plenty of "oil" available but there may be a growing shortage of the oil everyone wants.

If you pull into a service station looking for diesel and all they have is unleaded gasoline in three grades then you are going to be disappointed. Oceans of gasoline will not help you when your driving a diesel. Having an ocean of high sulfur crude in dozens of weights and flavors will not help a refiner that uses light sweet crude. This was the problem back in 2008 when the price went to $147. There was plenty of oil but there was a shortage of light crude.

I believe the compliance by OPEC is not lower than stated because they can't sell the heavy sour crude. They would produce more light crude if they could.

Secondly the demand inside the OPEC countries is exploding higher. I touched on the "land export model" and its ramifications in these pages last week. Jeffrey Brown pointed out at the ASPO meeting last weekend that consumption in Saudi Arabia is rising by 6.9% per year. Other major OPEC exporters are seeing demand rise slightly less than that but still at a rate well over China's projected rate of increase.

Chris Skrebowski, a former BP oil analyst, found that 45% of current oil production comes from a very narrow reserve base covering only a handful of major fields. Using the latest IEA numbers these select fields supplying 45% of our global production are depleting at an average of 7% per year and despite additional drilling their total production has declined consistently since 2002.

When you combine the roughly 6% increase in demand inside Saudi Arabia and other OPEC nations and the average 7% decline rate of production in the fields producing 45% of our oil you get an alarming drop in the amount of oil available for export. That roughly 13% decline in exportable oil encompasses all grades but PRIMARILY the grades most exported and that is light crude.

Add in the decline in production from Canada and Venezuela and there is a stealth decline in excess capacity. With every 1,000 barrel decline in production from some field in OPEC there is an increase of 1,000 barrels of excess capacity that is drawn upon by that OPEC nation.

Over the last two years the IEA has projected a conservative annual decline of 3.87 million barrels of production due to depletion. (-4.5%) That nearly 8 million barrels of decline was offset by 4.7 mbpd of new projects in 2009 and an estimated 3.2 mbpd of projects completed in 2010. Depletion was almost entirely offset by new production over the last 24 months but during that same period increased demand inside OPEC rose by more than a million barrels and increased demand globally accounted for another million or so barrels. On a side note the new production in 2009 of 4.742 mbpd was the largest increase in a decade and nearly 2.0 mbpd larger than any expected annual increase through 2020. It was a fluke, a one-time surge in production that was the culmination of several 5-7 year projects completed in 2009. The AVERAGE of new annual production completed since 2003 and expected through 2016 is 3.047 mbpd. That is far less than the combination of new demand and current depletion rates. Megaprojects Database

The bottom line is that we are on the edge of a precipice. The general public, including the vast majority of analysts still believe the OPEC lie that they have 4.0 mbpd of excess capacity. They may have it but I seriously doubt it is light crude. The smartest guys in the hedge fund room, those that get paid a fortune to read between the lines on research reports and IEA, EIA, OPEC press releases may have figured out that we are coming to a point where the global economy will gain traction, oil demand will surge and we will find out that the OPEC emperor has no clothes or in this case no excess capacity in the type of oil the world needs.

There is some reason why oil prices are holding in the low $80s when all the outward signs point to an excess in supply. The dollar is being blamed but I suspect we are moving closer to a new energy reality with each day that passes. That reality is going to be a return to conditions we saw in 2008 only with permanent consequences.

Jim Brown

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