What The OPEC News Really Means

As I write, we have just received news from the meeting of OPEC oil ministers taking place in Vienna. The production cut that some were hoping for is not coming. Maybe it is just my increased focus on energy, but I cannot remember so much attention being paid to an OPEC meeting since the late 1970s. The fact that "no news" is such big news shows the level of anticipation that existed. The main reason for that interest is that some cracks are appearing in the cartel. A group of smaller producers led by Venezuela have been openly calling for a cut in production of around 5 percent going in. The two biggest producers, however, Russia and Saudi Arabia, remained opposed to a cut in production.

Each of those has their reason. Russia seems to see the prospect of pain amongst U.S. producers as desirable and has to fund an increasingly aggressive foreign policy in the short term. The Saudis, on the other hand, are less concerned about geopolitical matters but are experts at playing the long game. For them, it seems a year of low prices is not particularly noteworthy, and it is too early to react. History told us going in that the Saudi view would prevail and that is what eventually happened.

In the immediate aftermath, though, what is interesting to me is that the reaction in oil futures hasn't been as large as I expected. Yes, we lost around 5 percent in the 15 minutes or so after the announcement, but that only took us to levels that were prevalent just a couple of days ago. This would indicate that the news was fully priced in at levels around $40 before yesterday's push up to close to $42. That jump was presumably driven by rumor and probably by traders simply playing the odds.

By that I mean that buying oil before the announcement made sense from a risk/reward perspective. If, as eventually happened, nothing changed then we would return to where we started, leaving you with a small, manageable loss. If, on the other hand, OPEC had gone against what was expected and announced cuts the potential profits were huge. A long position going in made sense.

That, of course, didn't pan out, so the question for traders and investors is, what now? From a fundamental perspective it is no secret that we have an oversupply of oil right now, so unless either demand picks up substantially or non-OPEC producers are forced into big cuts, meaning bankruptcy in the case of many small producers, a move down looks inevitable. That said though, the fact that the $40 level seems to be holding initially gives me pause. (In fact 39.62 was the low on the first drop, but that was quickly followed by consolidation above $40.)

Even if we do turn tail again there is still the August low of $37.75 to get through so an immediate massive crash looks unlikely. That indicates to me that somewhat cautious longs may be the way forward; there will be ample opportunity to stop out if the decline is gradual, but as the short oil trade becomes more crowded the chance of a serious bounce increases.

As to what could cause that bounce, I do have a theory. Even though the Saudi and Russian view has prevailed this time around the production cut camp does have a valid point, there is no doubt that prices at these levels are causing a number of problems for some countries. Around $40 is actually, from the perspective of historical pricing, not that low, but many current projects were started based on price expectations of a minimum of $60-65 so that is not the point; many newer wells are simply not viable at these levels and cuts to planned spending will have to be made if prices remain depressed.

Some of the smaller OPEC nations cannot stand the political pressure that will result if social programs and investment have to be cut significantly, so they are fighting for their very existence, not just for short term benefit. Given that level of desperation and the desire of Saudi Arabia to keep OPEC intact, some concessions are a distinct possibility, but they don't necessarily have to come in the form of actual cuts.

As the ECB has amply demonstrated over the last few months, talk from a powerful body can move markets significantly, regardless of what action is finally taken, and, as we all know, talk is cheap. Some kind of tacit agreement to begin making noises about production cuts would maybe be the only thing that could satisfy both sides of the OPEC split. It would come as no surprise at all to start hearing a few hints at cuts once the dust from today has settled and, given that it seems that the world and its dog are now short oil that would cause some huge short term spikes.

In other words, what we have now is the same as the situation that traders saw going in to the announcement. Even though logic dictates that the price will fall, a bias towards long positions in oil with tight stops offers a very tempting risk/reward profile and is therefore the trade that I would prefer, but then it should be noted that I am a contrarian by both nature and training. One thing, though, is for sure…The next OPEC meeting will once again attract a lot of attention and speculation, and for traders that makes it something to look forward to with anticipation.