Will OPEC's Big Gamble Pay Off?

By Markets Fool.com


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The stock market continues to trade near all-time highs, with the Dow Jones Industrials and other major market benchmarks trading near the unchanged level Thursday morning after posting solid gains during the first half of April. Yet the real action right now is in the energy market, where crude oil prices have consolidated their gains after a huge jump that took West Texas Intermediate to its highest level so far in 2015. Even as consumers celebrate low prices at the pump and fuel-intensive businesses improve their financial results on the back of cheap energy, oil and gas exploration and production companies have taken huge hits from the plunge in crude prices. In this situation, the OPEC oil cartel has sought to inflict pain on U.S. producers, and the big question is whether this major gamble will actually result in a further rebound in oil prices or a new lower range that will benefit consumers worldwide.

The ultimate price war
No matter what business you're talking about, supply and demand play a major role, and the entities that control the most supply have the most command over a particular market. OPEC produces about 40% of the world's crude and represents about 60% of oil available for export, and therefore it can have a major impact on prices worldwide. OPEC said earlier today that it expects demand for its crude to rise slightly this year, helping to make up for falling supplies elsewhere.

The latest OPEC report reflects a hoped-for payoff from the cartel's overall strategy. Typically, when oil prices fall, OPEC cuts production in order to stop declines in their tracks. Yet late last year the cartel chose not to make big production cuts, instead allowing prices to plunge. As a low-cost provider of energy, major OPEC players such as Saudi Arabia could afford to wait out a period of low prices better than companies operating in higher-cost areas like the U.S., where more expensive unconventional drilling methods such as hydraulic fracturing and ultra-deepwater offshore drilling were only economically viable with oil above $100 per barrel.

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Now, OPEC believes the U.S. oil boom will end this year, pointing to a drop in drilling rigs as evidence that new production activity is slowing. As wells' production naturally dwindles over time, the net result will be a decline in overall oil output volume beginning in the second half of 2015.

Can the cartel hold?
The big question, though, is what will happen next. Even if production stops growing, it will take years for capacity to drop back to pre-boom levels, and that could keep prices depressed. That, in turn, will cause pressure within OPEC to consider other options.

Already, discord within the cartel has started to appear. Earlier this week, OPEC member Iran recommended cutting production by 5%, and other hard-hit countries have also hesitated to support Saudi Arabia's strategy of keeping exports high to squeeze out foreign players.

Going forward, OPEC will have to walk a fine line. If prices recover to previous levels, it will only entice U.S. producers to boost their drilling activity again. Yet if prices stay where they are, it will be harder for OPEC to maintain its grip on the oil market as its less-prosperous members suffer from falling revenue.

In the end, OPEC is making a huge gamble that cutting prices will lead to a long-term competitive advantage. That investment might well pay off, but the risks if it doesn't could destroy the cartel as we know it. Those high stakes show just how important the oil market is to the global economy as a whole.

The article Will OPEC's Big Gamble Pay Off? originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.