Why you shouldn’t believe OPEC
By Marin Katusa, Senior Editor, Casey’s Energy Opportunities
In December 2008, after OPEC warned of “substantial cutbacks,” I voiced my strong opinion that the members of the Dirty Dozen would cheat, because cartels always cheat. Sure enough, despite all the talk about production cutbacks, even more oil flowed out of OPEC.
The harsh truth is that the whole honor and brotherhood thing may work for the Three Musketeers, but it’s a non-starter when, like the OPEC members, you have to foot the bill for hefty social programs.
On April 19, the Algerian energy minister said that OPEC would probably do nothing to restrain rising oil prices, despite concerns that persistently high energy costs would hurt the fledgling global economic recovery.
Take his comments with a pinch of salt.
With OPEC members currently violating production quotas at the same time that demand from industrialized nations is stagnating, our bet is that the 13-month rally in crude will soon come to an end and prices begin to fall over the next month.
What does this mean for investors? For reasons I’ll explain, get your dancing shoes on – the profit party is about to begin.
Prisoner’s Dilemma: Why Do Cartels Cheat?
Imagine you and an accomplice have been arrested for a crime that you did commit. The police lock you up in separate rooms and take their time in talking with you.
While you’re nervously waiting for the interrogator to arrive, you wonder what’s going on with your accomplice. Is he or she spilling the beans and sacrificing you in order to save their own skin? Or are they sticking to the prearranged story?
When your interrogator finally arrives, you realize your options boil down to these: 1. You can either confess to the crime before your partner does and go free.
2.You can remain silent (and pray like mad that your accomplice does too), and you’ll both get a more modest punishment.
3.You can wait until your accomplice confesses everything before you do, in which case they’ll go free while you’ll go to prison for years.
Now, if you trust your accomplice completely and they you, you know both of you are going to keep your mouth shut because all you’ll probably get is a slap on the wrist.
But what if the person in the other room is Libyan leader Muammar Gaddafi, or Venezuelan president Hugo Chavez, or Iranian president Mahmoud Ahmadinejad? Would you really trust any of them to put the interests of the group ahead of their personal self-interest?
Many readers will recognize this as the classic Prisoner’s Dilemma, but it is equally applicable to the situation in today’s global oil politics. Especially in that, regardless of what your accomplice does, you’re always better off betraying them.
Which is why when a cartel like OPEC sets an artificially high price by restricting the supply of a commodity, each member of the cartel always has an incentive to cheat. By offering the commodity at a slightly lower price, just one member of the cartel can attract all the customers and enhance their profit.
And if you’re Hugo Chavez and have quite a few expenditures to meet, these profits aren’t just a nice-to-have, but essential to retaining your tentative grip on power.
The (Real) Future of Oil
Members of OPEC have no choice but to cheat. They’ve cheated in the past, they have done so recently, and they will do it again in the future. In the current context, global output is rising faster than the demand for oil, even with the rising demand from emerging countries. While China and India, among other emerging economies, account for a large and growing share of the oil market, the United States remains the biggest consumer of crude oil. And U.S. demand for oil, along with the 30 countries in the Organization for Economic Cooperation and Development (OECD), is decreasing. In fact, the 2010 U.S. daily demand for oil is expected to drop by almost 2 million barrels from last year, while OECD consumption is down 8.3 percent from 2006.
At the same time, OPEC may be creating a surplus in the market, with output rising to 29.2 million barrels a day in March 2010, a 5.6% jump from March 2009. Of course, this doesn’t take into account non-OPEC producers, which are also expected to boost their production this year by about 600,000 barrels per day.
Amongst OPEC members, compliance with quotas fell to 53% in March, with Venezuela, Nigeria, and Saudi Arabia increasing production, even as the organization said it will need to pump less than previously estimated this year.
The Pump Jack of Profit
As you would expect, the combination of rising production and depressed demand is leading to a stockpiling of oil by countries and companies alike. Basic economics dictates that this makes US$87 a barrel unrealistic – prices are set to fall.
Of course, who are we to complain about low oil prices? Lower prices are a big plus for the broader economy, just as they are when you are able to pay less at the gas station. But it may surprise you to also learn that falling oil prices create a lot of investment opportunities. Case in point, just after the price of oil crashed in the second half of 2008, our subscribers were able to lock in profits in excess of 50% in just six months – through very conservative energy investments such as Nexen (T.NXY).
How? Using Nexen as a good example, we were able to use volatility to our advantage and pick both the right entry point and the right timing to buy the company’s shares just before they took off.
If you missed the boat the last time, don’t worry because the imminent correction in oil prices we expect will again allow you to get positioned in great companies, at great prices. But don’t put off planning your entry into the sector – that should start now, in anticipation of the enormous potential for profits that is coming.
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