What the Algiers Deal Means for Crude Oil Prices

Editor's Note: Kent just returned from the recent International Energy Forum in Algeria. Media pundits are dismissing the Algiers framework, but Kent wants every investor to know that the deal is in fact very important for oil prices, now and over the coming months. Here's Kent... 

What a difference a few days can make for oil.

Earlier last week, oil was drifting down under the weight of doubts about the rumored OPEC oil deal. Then, on Wednesday, several OPEC oil ministers announced that they'd agreed to cap production.

Almost instantly, U.S. oil prices shot up 6%. But come Thursday, the enthusiasm had waned, as traders actually looked into OPEC's oil deal... and didn't like what they saw.

Now, as with any supposed deal between countries that are at each other's throats, the devil will be in the details. That's certainly the case here.

But analysts' reports calling OPEC's announcement a complete failure are wide off the mark.

So today, I'm going to walk you through the details of this plan...

And show you exactly why this deal will be a game-changer for oil...

An Oil Deal Will Help That All-Important Market Balance

Now, OPEC had to move on oil production or face a snowballing financial mess. Wednesday's announcement brought welcome relief to the oil market, with prices spiking more than for any trading close since Feb. 12.

Algiers dealOf course, back then, WTI spiked from a low of $26.21 a barrel. As it turned out, Feb. 12 marked the low ebb of the oil pricing cycle in one of the worst downturns in memory. When the markets closed in New York on Thursday, WTI had risen more than 82% from that low.

But analysts have always been hard-pressed to determine just what it is that might create a lasting jump in oil prices. The global market continues to face a glut of oil. What's more, there are places with large, easily extractable reserves - should prices make doing that worthwhile.

That prices have been rising anyway shows that a balance is in sight. Now, this balance doesn't mean that there's only enough oil on the market to meet short-term demand.

As I've explained before, that kind of "just-in-time" approach to supplying oil would guarantee very unstable prices.

Instead, this balance involves matching expected supply with demand, with a cushion to cover any emergencies.

And that's where OPEC's announcement comes in...

OPEC's Plan Isn't Quite "There" Yet - but It's a Start

There was virtually no chance for OPEC to lay out anything but a general statement of intent before delegates left the International Energy Forum (IEF) ministerial meetings in Algiers.

Now, here's what that "sketch" of a plan looks like: OPEC has agreed to put monthly cartel aggregate production at between 32.5 million and 33 million barrels a day.

This is in line with the cartel's monthly output for January 2016 - the "Doha freeze" levels which happened to be historically (almost ludicrously) high.

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This also puts overall OPEC production at unsustainable levels. You simply cannot produce that much over any moderate period of time without significantly damaging reservoirs, along with future revenue flow, in many producing countries.

Of course, production has actually increased since January, as producers both inside and outside the oil cartel wrestled for market share in a destructive zero-sum game that ended up keeping prices down for everyone. That just made things worse for countries that depend on oil sales for their finances - including all of OPEC.

So using January's production figures addresses the basic production-side situation and provides a readily available cap. In other words - despite what some talking heads may be saying - this is not a production cut, just a targeted upward limit.

But announcing that goal was the easy part.

What comes next will be much harder...

Tall Order: OPEC Must Determine How to Divide Production

OPEC members face a daunting task, made more difficult by each member's disparate (and not infrequently desperate) domestic circumstances - not to mention the open rebellion and hostility in the ranks right now.

The group will have to decide which member countries get to produce how much oil under the January limit.

Crude oil pricesThey'll have to assign quotas.

Every month, the cartel determines expected global oil demand and deducts the forecasted supply from worldwide non-OPEC production. What's left is the so-called "call on OPEC" - the amount of oil the market needs OPEC to supply.

This "call" is then divided among cartel members through the monthly quota system.

But reintroducing these quotas will be a problem, because of Iran and Iraq. While both are members of OPEC, neither has had a monthly quota for years.

And yet capping production without their involvement will be impossible.

Now, when it comes to Iran, things look better than last time. When OPEC last discussed a production cap, in April in Doha, Iran didn't even attend the meeting.

So when Saudi Arabia insisted that Iran agree to any deal, the production cap was dead in the water.

This time around, however, the Iranians did attend.

But another important party didn't...

Taller Order: Getting Russia on Board

You see, regardless of what OPEC agrees to internally, any production cap will be unsustainable without the agreement of major non-OPEC producers - a group led by Russia.

Getting them on board will be OPEC's second step.

Now, Russia is currently producing an estimated 11.5 million barrels a day, a level that is unsustainable.

Russia is moving production up-front from a basin system that is already in marked decline. Pumping out whatever they can get from mature fields is reducing pressure to an alarming level. That guarantees a steeper decline in extractable reserves than would otherwise be seen.

So it was understandable that Moscow was indicating support for a cap both at Doha and Algiers. That would let the Kremlin ease off the throttle and reduce oil production to more sustainable levels.

But at the moment, the problem is that Russia has yet to chime in on OPEC's oil cap plan. If the Kremlin decides to provide lip service to the oil deal, but continues competing for market share behind its back, OPEC's attempt to limit oil production will fail.

So expect to see intense negotiations between OPEC and Russia.

But that still leaves out another major oil producer...

OPEC Had Better Hope U.S. Producers Play Ball

The bulk of the world's extractable, unconventional (shale and tight) oil reserves are right here in the United States. That makes America's impact on any oil deal crucial.

But unlike the other major producers, the U.S. has absolutely nothing in the way of a "national oil company" or centrally controlled, national oil-production policy.

That means U.S. producers cannot sit at a table in Algiers and commit a national position to any agreement.

At the moment, the U.S. impact on global prices is still largely a result of crude import levels. While American extractors are now allowed to export oil, it will take some time before that has a tangible effect.

OPEC will have to hope that its production cap doesn't raise prices enough to make it possible for U.S. shale producers to flood the market...

Where OPEC Goes from Here

So as you can see, the agreement from Algiers is still a threadbare framework with little substance.

A considerable amount of negotiations must now take place inside the cartel, where the ongoing animosity between Saudi Arabia and Iran must be addressed on a much broader level than simply oil prices.

And then there is the necessity to bring outside producers like Russia on board while trying to predict what increasing production levels in the United States (a probable given the expected rise in market price) may mean to the cap.

Until the deal is finalized, prices should reflect guarded optimism. Mind you, we'll still see bouts of volatility. Remember, the key here is to raise the expected floor of oil's price range, not focus on the ceiling.

And when it comes to securing and raising that floor, OPEC's eventual deal will be highly effective - if successful...

Now, the complete OPEC formula is supposed to be announced at the cartel's next scheduled meeting at its headquarters in Vienna. That takes place on Nov. 30. But the reality requires one or more meetings be held both inside and outside OPEC before then.

As a result, I still predict that at least one extraordinary meeting will be held within the next four to six weeks to include OPEC, Russia, and perhaps other producers.

I'll keep you posted.

For up to the minute updates from these meetings, click here to get my complimentary Oil & Energy Investor briefings.

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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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