How To Trade The OPEC Meeting

There has been a lot written, and even more said, about the "unofficial" meeting of oil producers that will take place early next week in Algiers. OPEC members and a few influential non-OPEC members will use the occasion of an energy conference there to meet on Tuesday to discuss possible action in support of oil prices, or, to put it more simply, to talk about a production cut, or at least a freeze. The talk from all of the participating nations has been that a deal is "possible' and has focused recently on what would be an appropriate level at which to cap production. That makes it sound as if a deal is coming, but traders and investors shouldn't be holding their breath or sinking their life savings into oil futures.

The talk has given some support to the market over the last week or so, but it should really come as no surprise; I wrote a couple of weeks ago that a lot of talking of books was coming. Of course there could be an agreement, but given the geopolitical realities and the current state of the oil market it looks unlikely. Firstly, participation by Saudi Arabia and, to a lesser extent, Iran is a necessary precursor to any freeze or cut, and agreement between those nations would be a shock.

Saudi Arabia is essentially a Sunni Islam country, while Iran is Shia, and that divide is seemingly irreconcilable. The two sects are battling for control of the region, and are currently fighting proxy wars in both Syria and Yemen. In those circumstances neither is likely to agree to, or more importantly stick to, any agreement that could help the other side, regardless of the benefits that may accrue to themselves.

There were hopes earlier this year that that may change when the Saudi's replaced Ali al-Naimi, the long serving oil minister who had explicitly asserted that there was no chance of a production cut, with Khalid al-Falih, the former head of the oil company Saudi Aramco. What we have subsequently learned though is that while Al-Naimi refused to do anything about the global glut of oil, Al-Falih simply denies its existence. The approach may be different, but the end result is the same…no incentive to cut production.

Some would argue that while that may take a cut off of the table, the prospect of a production freeze is still a live one. That may be the case, but from the point of view of a significant and lasting effect on the price of oil, does that really matter? Freezing OPEC production at record high levels that are generally considered to constitute oversupply and waiting for demand to catch up may help eventually, but would have little immediate effect.

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In fact, if anything it could be argued that such a move would be counterproductive. It would quite possibly cause a quick spike in prices, but that and the prospect of a freeze would only encourage U.S. producers to increase output. Production here, of course, is not subject to central control but is driven by market forces. A lot of crude that is recoverable by fracking has been discovered in the U.S. but much of it has prohibitive lifting costs with oil in the $40s. Even the prospect of higher prices, though, will encourage the flow of oil here to increase.

So, what is a poor trader to do? Well, the answer is to sit tight for now and sell into any rally that comes after the announcement on Tuesday or Wednesday. There are three likely outcomes from Tuesday's meeting, and all of them will create selling opportunities.

The most likely outcome according to many analysts is an announcement that a formal meeting will take place to discuss action. That would act as a compromise of sorts; the Saudis and Iranians could continue to attempt to outpump each other, but any rally on the possibility of an actual agreement would give temporary respite to the OPEC members such as Venezuela who are suffering with lower prices.

Less likely, but still possible, is an announcement of an actual production freeze. Again, bearing in mind that that would be holding steady at record levels and would quickly be negated by increased U.S. production, a strong rally on that news would be a good chance to sell. The third possibility is that no agreement at all is reached, and oil prices drop sharply. That would likely be a sustained move, so selling after the announcement and the initial move would probably still be a profitable trade.

As two of the three possible scenarios involve a short lived boost to prices, going into the news short makes little sense. Selling short soon after any announcement, however, no matter what news that announcement may contain, looks like a winning trade.