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Nick Cunningham

Nick Cunningham

Nick Cunningham is a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA.

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Will OPEC’s Gamble Pay Off?

OPEC

The tentative deal that OPEC agreed to in Algeria last week has been met with a lot of skepticism, both because it might be difficult to finalize and because the size of the production cut announced was a little underwhelming. Nevertheless, the deal succeeded in one aspect, at least for the time being. Market sentiment has turned a lot more bullish since last week, with hedge funds and other money managers going long on crude.

In fact, speculators began taking bullish bets on oil just ahead of the OPEC meeting, a gamble that paid off when OPEC surprised the markets with a plan to cut production by between 200,000 and 700,000 barrels per day. Money managers stepped up their long positions by 24,131 contracts and options in the week ending on Sept. 27, an 8.1 percent increase from the week before, the largest gain since January. And short bets declined as speculators closed out positions.

Speculators profited from – and arguably helped fuel – a rally that began with OPEC’s announcement, with crude up more than 6 percent on the week. The market seems to be holding onto the gains for now, with Brent breaking through the $50 threshold for the first time since June.

To be sure, the OPEC agreement, which may not even go through, would do very little to alter the supply picture for the oil markets. The glut is expected to persist much longer than many had expected, global inventories are still at stratospheric levels, and inventories could build through much of 2017. The U.S. rig count is back up and overall production has stopped falling. That is a recipe for lower oil prices for much longer, perhaps through next year. The EIA sees oil prices averaging just $50.58 per barrel through 2017, just about where prices are currently.

But the reason that some speculators have grown more bullish is because OPEC has promised to prevent oil prices from falling again. The deal might do little to push the market towards balance, but at a minimum it provides a floor beneath prices. The cut itself could prevent any fall back to the low-$40s or below, while the move also signals that OPEC would be prepared to do more if the market ever needed heavier intervention. "This is a big departure for the Saudis," Citi’s Ed Morse said recently, referring to Riyadh’s about-face in terms of letting the oil markets sort out supply imbalances. Related: Why Libya Could Completely Derail OPEC’s Deal

"They did show they are going to defend prices," Rob Haworth, a senior investment strategist at U.S. Bank Wealth Management, told Bloomberg in an interview. "They don’t want to see market volatility below $40 and are willing to defend it."

That may not be enough to move the market to balance and fuel a price rally, but it is enough to assuage concerns about another meltdown for crude. That is giving traders some confidence.

On the other hand, OPEC may have solved one problem only to create another: should the cartel fail to come to an agreement at its November meeting in Vienna, the market disappointment could pose a much greater downside risk than if there had been no Algiers agreement in the first place. "OPEC has created its own Q4 risk to oil prices ... In raising expectations of a November deal to cut production, it also risks a steep price decline should it fail to achieve its goal of cutting output back to less than 33 million bpd," Barclays wrote in a recent note to clients.

Meanwhile, shale producers are not taking any chances, making a flurry of moves recently to lock in prices for next year’s production, Bloomberg reports. The hedges could provide drillers some certainty, allowing them to ramp up production. Shale companies are rushing “in droves” to hedge their production, BNP Paribas said, following the gains in 2017 futures prices after the OPEC deal was announced. “We are seeing significant producer flows which early estimates suggest could be the highest we have seen all year,” Adam Longson, commodity strategist at Morgan Stanley, wrote in a research note.

Of course, higher oil production from U.S. shale would cap any gains for oil prices. With OPEC defending the price floor and U.S. shale creating a ceiling, we could be in for an extended period of time with oil trading roughly between $40 and $60 per barrel.

By Nick Cunningham of Oilprice.com

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