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Is OPEC Playing The Oil Markets Again?

OPEC

Oil prices moved back up closer to $50 per barrel on the sudden surge in optimism surrounding an OPEC deal. With the meeting just days away, everybody is playing ball and sticking to the script, and the odds of an agreement have improved markedly compared to a few weeks ago.

Iraq offered three proposals to OPEC members, showing a renewed willingness to negotiate after weeks of disputing production data and demanding an exemption from the proposed cuts. Details of the proposal were kept quiet, but Iraqi officials sounded cooperative in an emailed statement. “Iraq’s legitimate demands should not be perceived as an obstacle to reaching a new agreement to freeze production,” Iraqi oil minister Jabbar al-Luaibi said, according to Bloomberg. Iraq is optimistic about “reaching a fair agreement that would take into consideration everyone’s interests and that puts an end to the glut.” Officials from Iran, Nigeria and even Russia also offered positive words about the prospects of an accord.

Oil prices shot up by more than 4 percent on Monday on the news. Oil has rallied once again in recent days after dropping into the low-$40s per barrel. Now back up close to the $50 per barrel threshold, OPEC has once again succeeded in jaw-boning the oil market.

Goldman Sachs hiked its oil price forecast this week by a substantial amount. The investment bank expects oil prices to average $55 per barrel in the first half of 2017, up sharply from the previous estimate of $45 to $50. The bank is now “tactically bullish” on oil. “With greater confidence that the global oil market can finally shift into deficit later next year, we now believe that there is a strong rationale for low-cost producers to deliver a swift production cut to normalize inventories,” Goldman analysts wrote in a research note this week. In fact, Goldman Sachs sees prices rising across a range of commodities next year.

Related: Oil Prices Move Higher As OPEC Optimism Increases

The optimism has not trickled over into the oil futures market, at least not yet. Hedge funds and other money managers have stepped up their short bets on crude oil ahead of the OPEC meeting, covering against a steep downfall in prices should OPEC fail to come to terms. While the short positions on oil were notable, trading volume in general is way up. Bloomberg notes that as of mid-November, oil price volatility was at a seven month high. Bets on oil futures reached 1.47 million contracts for the week ending on November 15, the largest trading volume in nearly a decade.

But since mid-November, oil prices have increased, suggesting that some oil traders are closing out short positions, which could be because sentiment around the chances of an OPEC deal have improved. Further gains are possible as shorts are closed out.

At the same time, John Kemp of Reuters notes that the oil futures curve still does not look very good. The market is still in a state of contango, in which front month contracts are cheaper than oil futures further out. That is a sign that the markets still expect the glut of supply to continue. In fact, the difference between front month oil contracts and delivery six month out are actually wider than they were back in September when OPEC reached the Algiers agreement, which suggests an even gloomier outlook than two months ago. In short, an OPEC agreement might spark a short-term rally, but unless they agree to real and sustained cuts, the poor fundamentals could ensure the price increases are temporary.

Related: Can OPEC Get It Right At Long Last?

That last point is also key. OPEC may agree to something, but the details matter. OPEC is now producing at least 236,000 barrels per day (as of October) more than they were in September. That means that instead of needing to cut between 200,000 and 700,000 barrels per day in order to reach the stated goal of bringing output down into the range of 32.5-33.0 mb/d, OPEC will now need to make even sharper cuts – somewhere on the order of 600,000 to 1.1 mb/d. On top of that, the latest reports suggest that OPEC is discussing a six month agreement rather than one that would last a year. The idea is that it would require less of a sacrifice for OPEC members, particularly for Iraq and Iran who are still holding out. Of course, if OPEC cuts for six months and then the agreement expires, the effort will produce very little in the way of balancing the market.

Finally, assuming OPEC does the unthinkable and actually agrees to substantive and sustained cuts in output, they will likely succeed in pushing up oil prices. But that then merely throws a lifeline to U.S. shale, which could come back to life if oil prices move closer to, say, $60 per barrel. Even today, with prices below $50 per barrel, the rig count has been climbing for half a year, and now stands at 588 rigs as of last week, up almost 200 rigs from May. Gains in the rig count will only pick up pace of OPEC agrees to cut its output.

By Nick Cunningham of Oilprice.com

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Leave a comment
  • Matt on November 23 2016 said:
    Dear Nick, please explain why a contango (higher prices on future contracts) is bearish for future prices - I learned it exactly the other way ...
  • Rupert on November 29 2016 said:
    What he's saying is that as the futures price is higher than the expected delivery price then the speculators are net short and so expect the price to go down which is bearish.

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