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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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OPEC Bears Feel The Squeeze

OPEC

Investors appear to be increasingly confident that OPEC is going to live up to its word. Professional money managers have trimmed bearish bets on West Texas Intermediate to the lowest level since August 2014 in advance of OPEC’s planned production cuts starting in January 2017. Volatility is also down to its lowest level in several years.

No one knows for sure what will happen with OPEC of course, but for now there is reason for optimism and there is a substantial probability that oil could see further upside. Some investors are now increasingly seeing the possibility that oil could be back to $100 a barrel within the next couple of years – a prospect that would have seemed laughable just six months ago.

There is significant confidence among many market participants that the oil markets will finally rebalance in 2017. That rebalancing is largely coming from the drawdowns in supply. Global economic growth is still slow but positive. Indeed, major emerging markets like China are expressing concern about global economic risks and a slowdown in their own rate of growth rather than a foreseeing an increase. Chinese leaders were out recently saying that 2017 growth in that country will likely be 6.5 percent or less – a prospect that portends greater demand for oil but a slowing pace of increased demand. The rise of electric vehicles and renewable power has similar negative consequences.

Broadly speaking then it looks like oil has upside from here, but upside based on supply considerations rather than demand growth. Last week in Riyadh, Saudi Arabian Energy Minister Khalid Al-Falih said that oil prices should recover in 2017 as OPEC fulfills its production cuts agreement. The next day, UAE Energy Minister Suhail Al Mazrouei made similar predictions.

All of these comments are helping to buoy confidence that OPEC will live up to its promises and lead the market to a balanced state. The resulting increase in crude prices is putting significant pressure on refiners. But it’s a more mixed bag for exploration and production firms. Related: Saudi Use Of Solar Could Boost Its Oil Exports

U.S. producers have been using the current rise in prices as an opportunity to hedge their production for the next two years. Over the last month an increasing number of producers have been locking in hedges that protect the price of their output for the next two years. Such hedges can be either good or bad for investors.

Just as hedges were a saving grace for investors and companies when prices were falling, the new hedges built at lower price points could be a shackle on producers as prices rise. There is a long identified trend in the markets of stock investors selling their winners too quickly and holding their losing investments too long.

Companies may suffer from that same psychological issue – witness the fall of 2014 when Continental sold its hedges for a windfall profit and then found that oil still had $30 per barrel of downside to go. Producers rushing to lock in today’s lower price are essentially committing to sell oil at a price that five years ago would have seemed absurdly low. It seems investors of all stripes – both companies and people - seem ever eager to sell low and buy high. When considering investments for the new year then, investors might look for firms that have a history of disciplined operations and prudent risk management rather than speculation on derivatives.

By Michael McDonald of Oilprice.com

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