The Reaction To The OPEC Deal Extension Is Logical, But Flawed

Those new to financial markets, and energy trading in particular, were probably somewhat puzzled by the price action in oil futures this week following the announcement by OPEC and some influential non-OPEC nations that they are extending the production cuts agreed last year for another nine months, until the end of Q1 2018. The logical reaction to that news would have been a spike in oil, but instead we saw a dramatic decline of around five percent once the announcement was made. That is easily explained in terms of trading dynamics, but one question remains. Is it a sign that we are heading lower or does it represent a good short-term buying opportunity?

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"But the rumor, sell the fact" patterns like this are extremely common, and are the logical result of declaring the intent to enact a policy before actually doing so. Various OPEC members have made it clear over the last couple of weeks that an agreement was coming, so traders inevitably positioned themselves for that in advance of any actual announcement. Those statements, however, also set the rumor mill grinding and the whispers began to assume that more was coming. The market began to price in deeper cuts, which were never indicated, and when they did not come the extension became a negative for oil. All those traders that had taken long positions rushed to get out, and the ensuing results can be seen on the chart. That proves a point that I have often made here, that market positioning and dynamics going into news releases are more important than the news itself, but when the longer-term implications of the news are considered the selling looks likely to be overdone.

There is no doubt that OPEC, even with Russia and the other signatories to the agreement, are not the power that they once were. However, they still account for around half of the world's current oil production, and there was some other, highly significant news that came out of the meeting. It appears that contrary to the expectations of many the new quotas have been largely adhered to. If that continues to be the case, the massive stockpiles of oil that were the real cause of the collapse in oil prices and have continued to put downward pressure on them will be reduced over time. Demand for oil is still increasing around the world as the long, slow recovery from the recession picks up pace and static supply from half of the world's production capacity is therefore effectively a significant cut.

Of course, conventional wisdom states that all that will happen is that production in North America and other non-OPEC areas will increase to compensate for that. The shale revolution has certainly unleashed the capacity for that to happen, but assuming that it will ignores the fundamental driver of output decisions in those areas…the market. The drop in WTI back below $50 is hardly likely to spur a rash of new wells, regardless of the OPEC action.

The fact is that, in general, shale oil is more expensive to produce than the conventionally drilled oil that comes from the Middle East and other OPEC countries. By cutting the supply of relatively cheap oil, therefore, the agreement takes away output that cannot easily be replaced in the U.S. or Canada. That doesn't mean that we are headed back to three-digit oil prices any time soon, but it does make the low to mid 50s look like the logical place for WTI to be. On that basis, a recovery to those levels from here, rather than any further decline, is only logical.