As I write, the world's leaders are meeting at the G20 summit in Argentina. There are, as always, lots of story lines surrounding the meeting, some financial in nature such as the chance of informal trade negotiations, and some not so much, such as whether Donald Trump's cancellation of his private meeting with Vladimir Putin indicates the end of their bromance. For energy investors though, the meeting will be watched with a different focus. Both Saudi Arabia and Russia are in attendance, so they will be watching for any signs of an agreement to cut oil output.
That question is being asked because of current circumstances. Crude oil has been in freefall, with both Brent and WTI having lost around a third since hitting highs in early October. There are some demand related worries involved as trade wars threaten to slow global growth, but the biggest reasons for the drop are supply related. A couple of months ago, those highs were achieved in anticipation of a disruption to global supply as the Trump administration's abandonment of the Iran nuclear deal with Iran and the resulting sanctions took effect.
Since then though, a few things have become clear. Firstly, U.S. production has been stepped up by more than imagined. In addition, the Saudis increased their output to help offset the expected loss from Iran but, most importantly in that context, that loss doesn't look likely to materialize. Despite a lot of tough talk, the sanctions on Iranian oil have been rendered ineffective by the granting of exceptions to a whole host of customer countries. The net effect has been that after a tight market for a few years as the OPEC+ agreement to cut output held and was extended, we are back to a glut.
Little wonder then that as Brent has dropped below $60/ barrel and WTI breached the $50-mark, talk has surfaced this week of a possible re-examination of cuts. The Russians, the largest of the non-OPEC signatories to the deal, and the Saudis, the de facto leaders of the cartel, were reported to be in discussions focused on the timing and scope of new cuts. That would suggest that supply restrictions are coming for sure, and just the details need to be worked out.
Given those rumors, you might expect crude to have reversed course and jumped in such a supply-sensitive market. As you can see, however, that hasn't happened. The drop in WTI futures was halted just below $50, but the bounce was anemic and short-lived.
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There is obviously some doubt in traders' minds as to whether the rumors are true, or at the very least if any new agreement will result in meaningful output reductions. So, do those doubts or the initial optimism have the best chance of being correct?
As always with anything OPEC related, the political situation in the Middle East will have a big influence on the outcome. The problem is that the Saudis feel that while higher prices benefit them in the short term, they benefit their regional rival Iran more. Even with the exceptions to the sanctions, Iran has a limited market for its oil, so is unable to step up production to offset low prices. Obviously, in those circumstances, higher oil is a plus for them.
In the current environment, where Saudi Arabia and Iran are fighting proxy wars in Syria and The Yemen, low prices coupled with the ability to increase output give the Saudis a significant advantage in financing those conflicts. There is also another, more pressing reason for Saudi Arabia to take some short-term pain for long-term gain by allowing prices to stay low…Donald Trump.
Trump has on several recent occasions claimed credit for the potential economic benefits of lower oil prices. As anger over the murder of the American resident and journalist Jamal Kashoggi has risen, Trump has stayed supportive of Mohammed Bin Salman and has given some of that credit to the Saudis. With the President as seemingly their only ally, not just in America but amongst all western democracies right now, acting to force oil prices higher would not be a smart move by the Saudis.
So, even though production cuts make sense for most of the original OPEC+ group, they may not do so for the Saudis, at least not at this moment, and that makes an agreement to cut immediately less likely.
There is, however, a way that everyone could get what they want, an agreement to cut in the future. That would at least halt declines in oil for now, with the prospect of a recovery before long, but would result in a period of pain for Iran, while also allowing Saudi Arabia to say to Trump that they had done what they could to keep prices in the face of enormous pressure from other oil exporters. It would, however, probably not cause a rapid jump in oil, as traders would remain skeptical given the history of OPEC trying to talk oil up before doing anything concrete.
Whether it comes out of the G20 summit this weekend or not, that looks to be the most likely outcome. From a trader's perspective though, it is not something worth betting on. As mentioned, any upward reaction in oil would be limited in the event of such an announcement, but if one doesn't come and talks break down, the current mood in the market would ensure another sharp drop. Better to wait. If there is a deal there will be plenty of room to the upside and time to get long, but the downside risk makes acting in advance an unappealing proposition.
By Martin Tillier for Oilprice.com