by Jim Rickards, Daily Reckoning:
Oil has had a spectacular run the past two years. From $29.42 per barrel on January 15, 2016, oil has risen to $57.36 per barrel as of last Friday, a 95% gain in less than 23 months.
Much of this gain reflects the determination of the world’s two largest oil exporters – Saudi Arabia and Russia – to limit output in order to firm up prices. The duopoly of Saudi Arabia and Russia has proved much more effective than OPEC at maintaining the discipline needed to control oil prices.
OPEC members such as Iran and Iraq are notorious for cheating on OPEC quotas. The duopoly is more disciplined.
Yet, this kind of manipulation is a two-edged sword. Saudi Arabia and Russia have as much interest in not letting prices get too high as they do in not letting them get too low.
Right now oil prices are at the high end of the range the duopoly consider acceptable. Oil prices have nowhere to go but down once Saudi Arabia and Russia do some cheating of their own.
Investors who move now stand to reap huge gains as the duopoly drive prices lower in order to protect their market share, and once again shut-in the capacity of their competitors in the fracking industry.
Despite the ebbs and flows of oil supply and demand, and technical aspects of trading, the overriding dynamic in global energy markets is straightforward. In any market, there are price takers and price makers. The only price makers in global energy markets are Saudi Arabia and Russia, if they act together.
Saudi Arabia and Russia, (the “duopoly”) together produce 25% of the world’s oil exports. That’s more than the next six major oil exporters combined, and those others have nowhere near the degree of coordination as the duopoly.
Equally important is that Saudi Arabia has the lowest production costs of any major producer, about $4.00 per barrel. It’s certainly the case that Saudi Arabia likes higher oil prices, but oil could sink to $10 per barrel, and Saudi Arabia would still make money while most other exporters would lose money or cease production.
The duopoly face a familiar dilemma that could confront any business. On the one hand they like high prices and the revenue that goes with it.
On the other hand, high prices have two perils…
The first is that high prices encourage competition in the form of marginal output that can take market share. The second is that high prices can produce a recession in developed economies that reduces oil consumption across the board.
Obviously the duopoly would like higher prices, but this just encourages output from marginal producers especially those using hydraulic fracturing technology (“fracking”) in places like the Permian Basin in Texas.
The solution to this dilemma is an optimization plan using linear programming. The way to model this is to ask: “What is an optimal price that destroys competition andmaximizes revenue at the same time?”
Saudi Arabia ran this program in mid-2014. They concluded that the optimal price is $60 per barrel.
Of course, just because the computer says $60 does not mean you can stick the landing in the real world. There are many factors that go into oil pricing including geopolitics, central bank induced inflation or disinflation, and technical trading patterns.
In particular, once a price moves radically in a macro market there is a tendency to “overshoot;” something that is quite common in currency markets for example.
Read More @ DailyReckoning.com