A New Beginning for Oil? – Analysis & Opinion

In a surprising move on Wednesday, the OPEC announced that it reached an agreement to impose a crude oil production cut, with specific details to be finalized when OPEC meets again on 30^th November. While benchmark oil prices, namely New York-traded West Texas Intermediate (WTI) and London-traded ICE Brent, shot up by more than 5% following the announcement, and global stock markets rose in euphoria, many analysts are now expressing skepticism at the impact of such a deal at improving the situation of oversupply that hangs over the global market for crude oil. 

I too, have my reservations and skepticisms about such a deal. While many see it as major oil producers relenting on pursuing individual market share aggressively, and a first step toward vital cooperation within the OPEC, I believe major producers have still a long way to go to address the current supply glut.

Fast Facts, Fast Figures

• OPEC’s first approved production cut since 2008

• Preliminary outline to reduce group’s daily production to 32.5-33 million barrels per day, from 33.2 million barrels per day in August

• Exact details of production cut not finalized, OPEC will meet on 30^th November to discuss and finalize plan

• Oil’s oversupply began back in 2014 when American shale oil flooded the market. In a bid to maintain market share, OPEC has ramped up production in response, worsening the situation

• OPEC’s 14 nations currently produce about a third of world’s oil, its members have intensified production as they compete with one another for market share, adding to the global oversupply problem

A Change of Policy?

While an agreement to cut production is seen as a surprise to many, it is admittedly a natural step forward in a market that has hung in oversupply for more than two years now. Arab oil producers, most notably Saudi Arabia, have been feeling the pinch of low oil prices on their fiscal budgets, weighing on government expenditure and social spending. 

Although oil is in abundance under the Middle East, which keeps production costs low, the reduced profit margins amid low oil prices has taken their toll. Arab governments have come to the realization that their reliance on oil for revenue has put them at the mercy of depressed oil prices, which would put pressure on fiscal budgets in the long run.

In an unprecedented move back in August, Saudi Arabia announced its first international bond sale that would commence in October, in an effort to shore up the Kingdom’s balance sheet and plug the budget shortfall as a result of low oil prices. Such a move clearly shows that the Saudis have awakened to the disturbing reality of persistent low oil prices.

Past efforts to finalize a production limit or cut have always ended in failure, due to the unwillingness of bitter rivals Saudi Arabia and Iran to cooperate and agree.  In previous iterations of attempted deals, the proposed plan was to freeze each country’s output at current levels. However, Iran has always objected, seeing itself at a major disadvantage in terms of market share as it tries to ramp up production back to pre-sanctions levels.

Image from: The Telegraph

The recent agreement to cut production highlights a shift in OPEC’s policy – rather than trying to maintain individual market share and therefore revenues by out-producing everyone else, a deal that could prop up oil prices would be more sustainable and tenable in the long run. It seems like the OPEC has come to the realization that mutual cooperation is necessary in a market where oversupply is projected to last well into 2018, potentially crimping the budgets of many governments.

Long-Term Turnaround, or Short-Term Reprieve?

While perhaps reluctant to cut production, OPEC’s move signals a change in its strategy of prioritizing market share over supply-demand dynamics and oil prices. Which begets the question – Does this mark a potential turnaround for oil prices?

According to the Oil Market Report published by the International Energy Agency, world crude oil oversupply in 2Q 2016 stood at 300,000 barrels a day. With a slowdown in China (the faster growing large consumer of oil) and the World Bank predicting a slowdown in worldwide economic growth, global oil demand growth is expected to wane. Concurrently, non-OPEC oil production is forecast to return to growth in 2017, adding more supply to a market with sluggish demand growth. This does not bode well for oil’s supply-demand dynamics and the current glut is not expected to ease anytime soon.

While Arab producers do have the advantages of low production costs, their main rival, higher-cost shale oil producers in the USA, have been actively cost-cutting and improving efficiency to stay competitive in this cut-throat marketplace. While their costs of production used to linger in excess of $60-a-barrel, this figure has come down considerably to the mid-forties. 

Higher-cost operations have been taken offline for now, but could quickly come online should oil prices rise sufficiently. Therefore, the concern here is that a cut in OPEC production would become self-defeating – an OPEC deal would raise prices in the short term, incentivizing non-OPEC producers to increase their production, increasing world supply again and bringing the market back to square one.

The other problem boils down to the framework for a production cut itself – how is it going to be implemented? What OPEC announced was merely a reduction in their combined output, but have yet to finalize any details on the specific limits on each member. I am certain no country is self-sacrificial and would willingly take the bulk of the production cuts on its own, especially when rivals Saudi Arabia and Iran cannot see eye to eye most of the time. How the production cuts are going to be distributed among member nations is going to be a big problem and will be closely scrutinized at OPEC’s 30^th November meeting.

Not forgetting that OPEC producers have a record of cheating on their production quotas.

With no proper enforcement in place and when the Law of the Jungle rules supreme, member nations may simply abandon their quotas and produce excessively. This could very well happen should any member face severe budgetary shortfalls back home and badly requires more revenue. 

Without any concrete plans at the moment, it’s not hard to understand the skepticism of market analysts. Many do not foresee a turnaround for oil prices in spite of the deal, adding that any gains in oil prices is likely short term and a clearer picture remains to be seen when market forces take over. However, most agree that it would help market rebalancing in 2017. 

At best, the current framework would lend support to oil prices in the short term and perhaps keep the low $40s out of the question. However, any significant rally in oil prices would bring in a flood of hedging, as higher cost producers seek to lock in higher prices. The flood of supply would bring down prices again, keeping any major rallies in check, and establishing a “ceiling” on prices. Without any further catalysts, I do not foresee oil prices breaking out of the range, between $40 to $55. In essence, the status quo remains.

Capturing the Slump in Charts – Technical Analysis of Oil Prices

How could I ever miss out on commenting on colourful charts laden with bizarre price action?

 

Looking at the 3 year weekly chart of WTI, the severe plunge in oil prices is obvious. WTI went from its highs of $110 in 2013 to its lows of sub $30 in early 2016, with very volatile trading ever since. While the round numbers (eg. $30, $40) do act as some form of support or resistance for prices, oil is struggling to break $50 at the moment. 

A closer examination of price action starting to late 2015 to the present reveals a long term Inverted Head and Shoulders Formation, a bullish chart pattern, with the “head” and “shoulders” circled in red. The neckline of the H&S Formation is $50, and prices have failed to overcome that level more than twice. Hence, $50 will be a closely monitored level for oil traders. A major breach above $50 could potentially turn the tide for prices, with perhaps higher prices ensuing.  

Zooming in to the daily scale, we see that prices have been trading in a range between the low $40s to the low $50s since June 2016, taking support from the 50% Fibonacci Retracement level of the larger downward move at around $44.30, and encountering resistance at the 61.8% Retracement level around $48.60. Oil is currently range-bound, albeit with much volatility as large swings occur on any news or inventory data.

With a murky technical outlook and an even murkier fundamental outlook for oil, much difficulty is encountered trying to predict the direction of prices. Technically, the level to watch should be $50, for a sharp and powerful break above that key level could open the door to higher prices.

The Take

Even analysts with the clearest crystal balls would have trouble forecasting the direction of oil prices, in a market so volatile and so affected by geopolitical events. Hence, neither technical nor fundamental analysis should be used independently in this case to make a case for price action. I believe that oil would remain range bound for the remainder of 2016, ending the year somewhere in the forties, perhaps the high forties. However, if the November OPEC meeting results in a concrete plan that trumps expectations, we could see a significant rally in oil prices. However, I maintain my skepticism at such an outcome.

Again, just my two cents worth.

With that, I conclude my post. This blog will go on hiatus for the next three weeks as the author will be unavailable for writing and publishing.