Why OPEC Cuts Will Fail To Prop Up Oil ETFs

Oil markets were handed a surprise last week after the Organization of the Petroleum Exporting Countries (OPEC) decided to slash production for the first time in eight years. The cartel will target an output range of 32.5 to 33 million barrels per day, according to a press release put out after the decision.

The reaction to the news was immediate. Prices for WTI crude oil jumped 5.3% on Wednesday and another 2.5% on Thursday and Friday to more than $48/barrel.

Popular oil-tracking ETFs such as the United States Oil Fund (USO) and the VelocityShares 3X Long Crude Oil ETN (UWTI) gained around 7.7% and 23.6%, respectively, between Wednesday and Friday.

At the same time, energy equity ETFs such as the Energy Select Sector SPDR Fund (XLE), the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and the VanEck Vectors Oil Services ETF (OIH) surged anywhere from 5.5% to 10.5% in the period. Energy is now the top-performing stock market sector of 2016, ahead of utilities and telecoms.

YTD Returns For XLE, XOP, OIH

Clearly, energy investors are excited about the unexpected news. But there's reason to believe that perhaps OPEC's latest decision won't have a lasting impact on oil market fundamentals, and that investors should take a more cautious stance on energy ETFs going forward.

Lack Of Pricing Power

The most obvious reason for not getting carried away with enthusiasm over the OPEC news is the lack of pricing power the cartel has.

Production cuts by OPEC eight years ago were effective in tightening the oil market because the downturn in prices was completely demand-driven (caused by the financial crisis), and there were no other major producers to open the taps and steal market share from the cartel.

Today the situation is much different. In the post-shale-revolution era―if prices rise high enough―U.S. producers will quickly come in and make up for any lost OPEC supply. This threat was the reason OPEC decided to famously hold production steady in late 2014 in an effort to maintain market share.

It's therefore somewhat puzzling that OPEC countries would reverse course on that policy, because just as production cuts proved ineffective in 2014, they are likely to prove ineffective today.

Cuts Unlikely To Materialize

According to a monthly report from the group, OPEC production in August totaled 33.25 million barrels per day. That means the targeted cuts would lead to a drop in production of 250,000-750,000 barrels per day.

While Saudi Arabia and its Gulf allies may be willing to lower their output to account for a share of that cut, other producers are likely to completely disregard the quotas (which still have yet to be decided on a per-country basis).

Iraq, in particular, is currently seeing the massive wave of investments in its oil fields pay off. The country's output surged 1.5 million barrels per day to a record-high 4.5 million in the last year and a half. There's little reason to expect Iraq to suddenly put the brakes on the tremendous growth its oil industry has seen.

Iraq Oil Production At Record High

Source: Bloomberg

Likewise, Iran―which will be exempt from the quotas altogether―is now seeing a rebound in its oil production to presanction levels. The country has boasted it will raise output by another 400,000 barrels per day or more.

Then there's Nigeria and Libya, two countries whose oil industries have been devastated due to various forms of unrest. They are also immune from the quotas and could see a rebound in output at any time.

All Talk And No Action

Will Saudi Arabia and its Gulf allies be willing to cut production as their rivals within and outside of OPEC produce without limits? Probably not; and even if they do, there will be plenty of producers that would gladly take their market share.

Based on the evidence, it looks like last week's OPEC decision was all sizzle and no steak. That means energy investors shouldn't count on the cartel to prop up prices, and instead assume that all producers will continue pumping oil at maximum capacity.

Contact Sumit Roy at [email protected].