How to profit as Opec throws in the towel

published 11 October 2016

161011-oil-price-b — Russia has joined forces with Opec in cutting production to maintain the oil price

Oil cartel Opec has given up on hoping that US shale oil producers will go bankrupt before its members do.

The world's oil producers have managed to endure two years of fighting for market share, leaving oil prices to find their own level in a semblance of a "free market".

But the pain has been too great. Saudi civil servants aren't used to taking pay cuts of 20%. There's only so much of that sort of thing a society can tolerate.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

So now they've called time on the war of attrition. They're determined to keep oil prices above $50 a barrel.

And with Russia chumming up with the cartel, they might just manage it

The world's oil producers have thrown in the towel

including me

Opec agreed to cap their output at 32.5 million barrels of oil a day, starting from next month. From current estimates, that'd be a cut of nearly a million barrels a day. That would be the first production cut in eight years.

That surprising level of agreement triggered a surge in the oil price. And yesterday, at another energy meeting in Istanbul, Russia decided to keep the momentum going. The country a non-Opec oil producer said it is ready to join the oil cartel in a deal to trim output.

Quoth Russian president Vladimir Putin: "Russia is ready to join the joint measures to cap production and is calling for other oil exporters to join."

The oil price hit its highest level since this time last year. Both Brent crude (the European benchmark) and WTI (the US one) are above $50 a barrel now.

They will of course, have to deliver on the production cuts to keep this going. But they'd have to be pretty stupid not to. And given the efforts it has taken to get to this point, it would be strange to fall at the last hurdle.

Won't a higher oil price just encourage US shale producers to ramp up production? Not necessarily, according to respected oil market analyst Gary Ross of US-based PIRA. He tells Reuters that "the timing of this is quite deliberate. Opec is doing this heading into winter and at a time when supply from non-Opec producers is down."

In short, demand will go up as the cold weather sets in. At the same time, low prices have forced shale producers to cut investment and shed workers over a prolonged period. It'll take them time to come back from that enough time to allow Opec to take advantage of higher winter fuel demand.

"The policy to push for market share is over. It's a matter now of going back to managing the market."

How to play the rising oil price

That'll be why our very own BP and Royal Dutch Shell have been doing so well recently. They're both still yielding well over 6%, so if you think that the pound will continue to be weak and oil will keep rising, this is a good way to play it.

Even if the current oil price isn't maintained, notes Malcolm Graham-Wood of HydroCarbon Capital, "from this valuation [the shares] still seem to have much to go for. They have cut costs out of all recognition as well as capex and [dividend] cover is OK if not super comfortable."

Another interesting angle is that the rising oil price also helps many emerging markets.

That's particularly important as investors get twitchy about the US Federal Reserve potentially raising interest rates in December. That's having a knock-on effect on the dollar. The dollar index is approaching a three-month high.

The last spike in the US dollar hit emerging markets hard, as we saw at the start of the year. So you might expect emerging markets to be vulnerable again.

However, if oil prices are rising at the same time as the US dollar (unusual, but it happens) that will offset some of the damage.

For example, Brazil is enjoying a storming run right now. It's been one of the best-performing investment markets this year so far. But despite that epic run, it could still have further to go if the oil price keeps improving. You can play the market with an exchange-traded fund (ETF) such as the iShares MSCI Brazil UCITS ETF (LSE: IBZL).

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.