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OPEC Has Abdicated Its Throne and You'll Be Surprised Who's Taking Control

By Matthew DiLallo - Feb 4, 2015 at 1:00PM

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OPEC has abdicated its throne as the leader of the oil market according to the CEO of Kinder Morgan Inc.

Everyone seems to have an opinion on where oil prices will go next. However, it's a debate we wouldn't be having if it wasn't for the fact that OPEC has backed away from protecting oil prices to the new role of protecting its share of the oil market by looking to squash its new rival. This ceding of control over price is why we've seen billionaires debate the return of $100 oil while OPEC's leader suggests a possible super spike to $200 a barrel if oil companies cut back too much on investment in new oil projects.

However, amid all of the turmoil and debate one thing is clear: OPEC is walking a fine line as it's putting its members' finances at risk in order to prove a point. Further, it's at risk of permanently losing its power over prices if it waits too long to act. At least that's the view of energy infrastructure tycoon Rich Kinder, who is the founder, CEO and largest shareholder of Kinder Morgan (KMI 0.54%). His recent comments on the oil market strongly suggest that by stepping away OPEC is ceding control of oil prices to the U.S. oil market. This means oil prices will be largely driven by how much American oil companies are willing to spend to drill new oil wells. Said another way, if there's money to be made it will be "drill, baby, drill" but if not they'll lay down their rigs and hold out for better prices. .


Source: Kinder Morgan. 

Interesting times we live in
At the company's recent Investor Day Kinder opined on the oil market providing his thoughts based on his years of expertise in the industry. He started by saying:

First of all, I think maybe the most important point is we are seeing a fundamental shift in power here. As we all know, OPEC has in effect abdicated its role as the force setting oil pricing in the world. They could try to reclaim that at some point. The longer they abdicate -- it's kind of like an Eastern European king after World War I; once they are gone for a while, the people get used to them not being there and it was very hard to restore the monarchy in those Eastern European countries.

No one expected OPEC would allow oil to fall below $100 as it was well documented that most of its members needed that oil price, or more, to balance their budgets. Because of this it was a widely held view that OPEC would protect oil prices at that level by reducing its output in order to keep prices in line. However, by holding the line on production, which sent oil prices over the edge, OPEC has walked away from its throne of dictating the price of oil. In doing so it handed over control of oil prices to a new force. Kinder noted this by saying:

A free-market approach in the future, is a very interesting concept and I think will stand a lot of old assumptions on their head. One of those things is that I believe it will make the U.S. a much more important player in the role of setting worldwide prices and I think we are already seeing that today.

By handing over control to the free market, OPEC is in a sense handing over control to U.S. oil producers as America is the leader of the free market economy and now the world's largest oil producer. This means oil prices will be driven by the investments made by U.S. oil companies to bring new oil supplies to the market. So, when oil companies cut back on drilling for new wells, which is what's happening right now, it will eventually lead to lower oil supplies and eventually higher oil prices. . As this dynamic plays out it should yield a new long-term price of oil that's driven by economics instead of OPEC.

What this means for oil prices
In stating the obvious, free markets are governed by the laws of supply and demand. Right now supply is ahead of demand, which is why oil prices have plummeted. Because OPEC is no longer in charge of setting prices, by dictating supply, its up to the free market to make adjustments. While the oil market adjusts to this new reality, it will take some time to settle out. Kinder points this out by saying:

Now I believe it is impossible to predict when or at what price oil will reach its bottom. I see the OPEC Secretary General ... said he thought we had reached the bottom at the mid-$40s. I don't know; it's like catching a falling knife. I don't know when it is. But one thing I'm certain of is that the price to sustain supply in the world oil market cannot be $45 or $50 a barrel. It just won't work.


Source: Kinder Morgan.

As Kinder points out the current price of oil won't work in a free market as few producers can't make good money drilling for oil at that price. A lot of shale plays, for example, really need $70-$80 oil to earn a decent enough return, especially emerging plays like the Niobrara, Mississippian Lime and the Tuscaloosa Marine Shale. Meanwhile, some ultra-deepwater projects can need oil in the $120 per barrel range to earn an economic return. Because of this the free market would never allow these projects to move forward as lower cost plays like the core of the Eagle Ford and Bakken would be developed first. So, at some point oil will have to go up in order to justify the investment needed to bring higher cost plays and projects online, while at the same time the free market will put downward pressure on costs so that these projects could be economical under lower oil prices. Under this free market approach Kinder sees a free market price that will eventually work for everyone, assuming that OPEC can't wrestle control of the market back by dramatically reducing its output. Here's what he has to say about this future free-market price:

What is that price? You know, there's a lot of factors in determining what that clearing price really is on a worldwide basis. Among the factors are the fact that I think you will see substantial reductions in the costs of drilling and completing upstream projects in the future as a result of this, just as we saw back in the Great Recession in 2008, 2009. ... My own token thought is that it's probably in the $65 to $75 range that it really takes in order to have an oil market where the supply is sufficient to meet the demand on an ongoing basis.

According to Kinder, oil needs to be in the $65-$75 per barrel range over the long-term in order to have enough economical supply to meet demand. That's that range that most oil developments today are profitable, while its also a range that, assuming that costs deflate, would enable oil producers to make money on projects that currently would be uneconomical in that range.  

Investor takeaway
According to the CEO of Kinder Morgan, OPEC is playing a dangerous game by abdicating its role in dictating oil prices. It's running the risk that the free market will take control and won't let go, as it will reprice not just oil prices, but the price of oil-field services. If that happens it means that America will play a key role in setting that future price. 

Matt DiLallo has the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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