Where Does Oil Go After The Largest Production Cut In History?

Right now, it is understandably difficult for anything to interrupt the coronavirus news cycle, even in the focused world of energy and commodities. This week, however, one thing managed to do that. On Thursday, there was a virtual meeting of what has become known as the OPEC+ group, and the meeting and its results were big news.

OPEC+ is the group of oil-producing countries that includes OPEC and a few select, non-OPEC oil-producing countries, most notably Russia. They first came together in 2016 to cut crude output in an attempt to stabilize prices and have adjusted the level and distribution of those cuts several times since. As you can see from the chart, oil prices climbed significantly for two years following the agreement but fell dramatically at the end of 2018 before collapsing completely this year.

Part of this year’s dramatic collapse was due to the output restriction agreement falling apart at the start of last month, resulting in the biggest one-day decline in oil’s history. So, when OPEC+ announced on Thursday that they had agreed to cuts of 10 million barrels per day, it was big news.

The problem, though, is that WTI futures did this on the announcement…

There are two obvious questions. Why did oil futures drop so much on the announcement of the biggest output cuts ever, and what does it mean for prices going forward?

The first is the easier question to answer.

What we saw yesterday was a giant, repeated “buy the rumor, sell the fact” pattern. For a few days leading up to the agreement, rumors were rampant about what was to come. The possibility of a deal was first rumored on Thursday of last week, then seemingly confirmed on Friday, when Donald Trump announced that a deal had been done between Saudi Arabia and Russia. That caused crude to spike up over 40%, from an opening of $20.10 on Thursday, April 1^st to a high of over $29 just two days later.

Then, shortly after Trump spoke, it became clear that he had jumped the gun. When it was announced that there would be a meeting on Thursday to seek agreement, it was a disappointment rather than good news, and crude gave back some ground. By the middle of this week, however, the rumor mill had fired up again, this time predicting supply cuts of 15 or even 20 million barrels a day. After that, even the “biggest output cuts in history” were a disappointment and WTI futures (CL) dropped 20% from their intraday high.

So, where do we go from here?

In a way, traders’ disappointment at “only” 10 million barrels a day supply reduction is completely justified. There are no reliable data available right now, but most estimates of the effect of the coronavirus shutdown on oil demand are around 30 million barrels a day. Even if it less than that and even after the agreement, there will most likely be massive oversupply into an already glutted market.

Further declines have to be on the cards in the short-term because of that, but they may not be as massive as some are predicting.

The simple fact is that crude, from its January high of $65.65, fell over 70% to its $19.27 low. A move of that magnitude prices in an awful lot of bad news and makes it far less likely that the cuts will be offset by increased production from the U.S. and Canada. Pumping shale oil at those prices makes no sense. If anything, crude down here and the wave of resulting bankruptcies will see North American output also decline.

So, while we may be headed towards another break of $20, a push lower than the upper teens looks unlikely. Then, at some point, coronavirus restrictions will be lifted, and demand will increase. That is already happening in China. There is no way of knowing when that will come at this point and It will take time to clear off the backlog of stored oil, so there probably won’t be a “v” shaped bounce. If we do head lower next week though, it may be a good opportunity to pick up some cheap oil stocks in companies with strong balance sheets for long-term investments.