Why Did Oil Drop on an OPEC+ Output Cut and Will the Selling Continue?

Over the last twenty years or so, I have spent a lot of time teaching and mentoring aspiring traders. During that time, I have heard a lot of questions, but the most common one by far is why markets move in a counterintuitive direction after news. Normally, those questions are about stocks after earnings releases and the answer is often quite obvious. It may be that an EPS beat was achieved on lower than expected earnings, or that the numbers were boosted by a one off item and the adjusted number is actually lower than forecast. Or it could be the most common of all, that a good report was accompanied by a cautious or negative outlook.

When it comes to a counterintuitive move in commodity futures, though, none of those things apply. So, why did crude fall out of bed on Thursday, shortly after OPEC+ announced an extension to their production cuts? And, more importantly, is the bearish move going to continue?

Just in case you missed it, the group, made up of OPEC and several other producers with governmental control of output, most notably Russia, concluded a meeting on Thursday that had been delayed for a few days and announced that they were formalizing the until now voluntary cuts by Saudi Arabia of around 1 million barrels per day (bpd), and reducing output by nearly another million bpd elsewhere, including a half a million bpd output reduction by Russia.

Logically, that should have pushed oil prices higher, and yet, around three hours after the announcement, front end crude futures were trading more than two percent lower than Wednesday's close. 

There are several reasons why that might be.

The first is that while the action of reducing output suggests higher prices, the reasons behind it may not. Why would oil producing countries want to cut output? There are some who believe that it is a grand plot to force up oil prices and add inflationary pressure in the US to make Joe Biden look bad in the coming election year, but that is a little too conspiracy minded for me. Some cartel members would no doubt see damaging Biden as a plus if that were to happen, but OPEC typically makes decisions based on maximizing profits above all else, and that is probably the motivation here, too. That means that they are cutting output because they believe that if they don't, supply will race ahead of demand before too long and force prices lower. Or, to put it in simple terms, they see slower growth or maybe even a recession on the horizon.

Then there is the fact that OPEC+ output targets are just that, targets. They are not really enforceable, and the fact that the meeting was delayed due to disagreement about the path forward suggests that some smaller countries are not happy with this outcome. There is really nothing to stop them paying lip service to the idea of cuts, but still producing above their quota. The other wild card, of course, is non-OPEC+ production, particularly in North America. American and Canadian output is massive, and not subject to government control. If the companies that control that production see a chance to grab market share by increasing their own output, they will take it.

All of those things will have added to the second guessing of traders after the seemingly bullish news broke, but the biggest reason of all for the drop is the one that most often explains the seemingly inexplicable when it comes to a market's reaction to news, a buy the rumor, sell the fact dynamic. There have been rumors of a decent sized further cut by OPEC+ for a while and crude has climbed over the last few days as a result. The speculative positions that caused that pop will have been looking to bank a profit, and once a few big trades were unwound and oil started to head lower, there will have been a bit of a rush to the exit.

What matters here, though, is not necessarily why oil dropped on good news, but whether or not the selling will continue. How you feel about that depends on which of the above things you think is the biggest influence. If you believe that it is the fundamental worries about growth or the fact that the real reduction in global output will probably be significantly less than the announced amount, then yes, crude will continue to head lower. However, if you believe, as I do, that the reaction was more about market positioning and dynamics going into the announcement, then you have to believe that this is a temporary setback and there will be strong, probably sustained bounce once the dust has settled.

The deciding factor for me is that none of the fundamental factors that might have caused crude to drop on bullish news are new. They are all things that have been known for a while. OPEC's economists and forecasters have been pessimistic about global growth for a while, which is why this decision was what most people expected. In addition, some countries have been cheating on their quotas for years now, and North American oil output has been a big factor in pricing ever since fracking became a thing a decade or more ago.

Given that, the market's positioning going in seems to be the biggest factor here. If that is the case, then once everybody is squared up and starts to look at the future again a further cut in output will be seen as what it is, bullish for oil, and crude will claw back Thursday's losses and may well head higher still as the reality of a return to a tight market takes hold.