How a Surprising Alliance Could Shake Up the Oil Sector

This time last year, Marina and I were in Dubai. This year we are about 80 miles further west, in Abu Dhabi.

Like Dubai, Abu Dhabi is one of seven emirates comprising the United Arab Emirates (UAE). Founded in 1971 once the British relinquished control, the UAE is the second-largest Persian Gulf economy (after Saudi Arabia).

And while Dubai has morphed into a global financial and real estate center, Abu Dhabi remains based on a more traditional source for its immense wealth: Oil.

Which sets the stage for why Marina and I are here in Abu Dhabi. Yes, we do have a wedding anniversary in a few days and that has always been a nice excuse for an exotic trip.

But this time around there is also another reason for traveling here and doing that now.

Tomorrow, events in Abu Dhabi point to OPEC having a brand-new ally in the oil sector - one no one would expect.

Abu Dhabi Is the Real Power in the UAE

flagsWe left on a flight from Miami late on Tuesday to visit Abu Dhabi, the city ruled by Khalifa bin Zayed bin Sultan Al Nahyan (often referred to as simply Sheikh Khalifa).

After over 16 hours, we arrived late last evening local time. After ensconcing ourselves on the Executive Club level of the Etihad Towers, we promptly crashed.

This morning, the wall-to-ceiling windows of our 57th-floor residence provide a panoramic view of the two primary forces driving this Persian Gulf dynamo.

In one direction down the coastline is the Sheikh Zayed Grand Mosque, one of the world's great religious landmarks. It can house over 40,000 worshippers at the same time and is the devotional center of the country. In the other direction lies the skyscrapers of a modern city spreading out on the shores of the Persian Gulf, displaying the wealth of this city.

And there is a considerable amount of wealth here. The Abu Dhabi Investment and Development Authority is by estimated capitalization the largest sovereign wealth fund in the world.

Then there are the events of a few years ago.

As a consequence of the worldwide credit meltdown, Dubai became overextended and needed an immediate influx of financing to remain solvent. Sheikh Khalifa bailed them out.

Lest there be any doubt, the emir of Abu Dhabi and UAE's head of state gave a clear statement as to where the real financial clout lay...

The Persian Gulf Is Still Centered on Oil

The UAE, and Abu Dhabi in particular, occupies a pivotal position both in the economic development of the entire region and the policy dominating OPEC. Along with Saudi Arabia and Kuwait, the UAE remains a principal driver of the cartel's market strategy.

That strategy has reversed decades of maintaining oil prices in times of global oversupply by cutting production. Instead, a year ago OPEC spiraled prices downward by first keeping oil production constant and then increasing exports in the face of an oversaturated market. The defense has been one of protecting the organization's market share. [Editor's Note: Click here for Kent's newly released oil forecast.]

But that has come at an accelerating cost...

Defending that market share is only successful if non-OPEC producers cut their output. OPEC has made their position quite clear. This time around the rebalancing of available supply is going to come from the actions of others.

This has resulted in new and intensifying pressures within OPEC. All members must now run expanding budget deficits due to the low price of crude. While Saudi Arabia, Kuwait, and the UAE can weather the problem in the short run, others like Venezuela, Libya, Iran, Algeria, and Nigeria are in open and public criticism of continuing the policy of not cutting production to increase prices.

Much of the media coverage on the "defense of market share" has centered on the rise of unconventional (shale and tight) oil production in the United States as the target of the OPEC decision. Yet the total volume of American oil extractions is very difficult to influence by outside policy changes.

For one thing, unlike other major providers worldwide, production in the United States is not controlled by government-owned or administered companies. Rather, a patchwork of private companies comprises the sector. Without central control, it is far more difficult to influence the course of events.

For another, the timeline is an inordinate problem. While policy benchmarks are ultimately determined by market considerations, there are also corollary cycles of mergers and acquisitions, forward price hedging, varying access to credit lines, and a myriad of other factors that make it almost impossible to set benchmarks.

Especially in this case.

The Real Target of OPEC's Strategy Isn't U.S. Shale

As I have noted on several previous occasions in Oil & Energy Investor, despite the lack of any previous examples of such a market defense strategy, there is a decisive reason why OPEC needs to confront the shale/tight oil competition coming from the United States.

The reason is not direct impact on global volume levels. Until Congress changes legislation, the vast majority of American crude cannot be exported.

Therefore, at the moment, increasing U.S. domestic production influences worldwide supply only indirectly by the influence it has on reducing levels of imports. And quite apart from the current competition, those imports have been going down for some time.

Rather, with well over 80% of extractable shale and tight oil internationally located someplace other than North America, OPEC knows it has an oncoming problem. The United States and Canada may have been the first to bring unconventional oil on line. But the cartel will be battling such new sources increasingly in the future as development begins elsewhere.

The high visibility of laying the gauntlet down to American producers is actually the first dry run by OPEC of orchestrating a policy for the extended contest ahead.

Yet there have been indications emerging that another primary non-OPEC player is prepared for such conversations.

OPEC Is Starting Negotiations with a New Potential Ally

Despite some rather defiant public statements, Russia has been positioning for possible negotiations on oil production levels.

Now this also needs to be considered in context. While Moscow has the largest permanent observer delegation at the OPEC Secretariat in Vienna, it will never allow an outside entity to dictate national production levels. Yet as a nation, Russian production is centrally determined.

In addition, the Russian central budget does share a common element with all OPEC countries - it depends on revenue from oil sales. As such, Moscow is more receptive to overtures of a mutual production agreement, despite the public rhetoric.

Which is why Marina and I chose Abu Dhabi for this anniversary trip.

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You see, the Russians are arriving tomorrow.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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