3 key questions for the oil market poker game, ahead of OPEC’s meeting

Brent Nov16Volatility continues to dominate oil markets, as the above chart confirms.  Some weeks have seen prices move by over 18%.  These are extraordinary moves in a market which is very well supplied, with near-record inventory levels.  Some recent daily moves are equally extraordinary, with prices jumping $2.50/bbl on Tuesday.

The volatility highlights the power of the futures market to temporarily overwhelm anyone trading on the basis of physical supply/demand.  As I noted last month, futures trading in just the WTI contract has averaged around 10x physical volume.  So prices can take wild swings, without anything happening in the “real world” – especially when the automated high frequency traders get involved with their media-led algorithms.

Tuesday’s move, for example, was caused by speculators buying 300 million barrels of  oil via call options (betting that the price would be higher in H1 2017) – over 3x daily physical volume.  This was why the price soared.

The speculators particularly love “stories”, as these are impossible to prove or disprove.  So the story this year about an OPEC/Russia production agreement has been perfect for their purposes.  It is the “gift that goes on giving” as one major player told me.  But at some point, probably quite soon, the story will run out of road – you can’t keep bouncing prices around forever on speculation, if nothing ever happens.

It therefore seems worth looking at the 3 key questions that will need to be answered by the end of this month, if the promised production agreement is to mean anything tangible.  As always, this week’s Monthly Oil Report from the International Energy Agency provides valuable input:

Will there be an OPEC cut?  It is very easy to talk about stabilising output at today’s level, given it is currently at record production.  The IEA’s view on OPEC output is clear:

“OPEC crude output rose by 230 kb/d to a record 33.83 mb/d in October after production recovered in Nigeria and Libya and flows from Iraq hit an all-time high. Output from the group’s 14 members has climbed for five months running, led by Iraq and Saudi Arabia. In October, OPEC supply stood nearly 1.3 mb/d above a year ago.

“It has only been two months since OPEC last met in Algiers and announced it would examine how to set up a production ceiling of between 32.5 mb/d and 33.0 mb/d. OPEC also said it would seek to bring leading non-OPEC producers into the process. We can’t predict the outcome of the 30 November meeting, but we can see the scale of the task ahead. In this report we estimate that OPEC members pumped 33.8 mb/d in October, well in excess of the high end of the proposed output range. This means that OPEC must agree to significant cuts in Vienna to turn its Algiers commitment into reality.”

Would non-OPEC countries make a cut?  Again, the IEA is clear:

Unfortunately for those seeking higher prices, an analysis of the other components provides little comfort. The world’s biggest crude oil producer Russia will see its output increase by 230 kb/d in 2016, and sustained production at current record levels would result in growth of nearly 200 kb/d next year. With production also expected to grow in Brazil, Canada and Kazakhstan, total non-OPEC output will rise by 0.5 mb/d next year, compared to a fall of 0.9 mb/d in 2016. This means that 2017 could be another year of relentless global supply growth similar to that seen in 2016.”

What would happen if production was cut, and prices then rose to, say $60/bbl?  The head of the IEA gave their view in a Reuters interview on Wednesday:

U.S. shale oil producers will increase their output if oil prices hit $60 a barrel, meaning OPEC will have to walk a fine line if it curtails production to prop up prices.  OPEC members are due to meet in Vienna at the end of the month to push through the first output limiting deal since 2008.  If this decision pushes the prices up (to) around $60/bbl, we may well see a significant increase from shale oil from the U.S.  This level would be enough for many U.S. shale companies to restart stalled production.”

It is therefore clear that OPEC has an uphill battle ahead of it.  Of course, it is great fun, and highly profitable, to simply “wave away these facts” if you are a trader trying to profit from the “story”.  But this is a zero-sum game: in other words, the trader’s profit is someone else’s loss.  They are simply making money for themselves, and leaving the rest of the market to pick up the bill.

Of course, it is possible to believe that that OPEC and Russia will be forced by the downside risk to make real, and major cuts.  It is also possible to believe that “this time will be different”, and that most OPEC members won’t immediately cheat on the new quota, if an agreement is reached.

Clearly every business that uses significant quantities of oil needs to prepare a Scenario analysis of the possible outcomes from the OPEC meeting.  And this analysis needs to be realistic about the probabilities of success.  Does OPEC have a 90% chance of reaching and enforcing an agreement?  Is it a 50% chance.  Or is the whole story merely wishful thinking, with just a 10% probability of happening?  You have to make your own judgement.

Equally important, of course, is that you then spend time thinking about what would happen to your business and investments in each of these Scenarios: if (a) prices rise to $60/bbl (b) stabilise around today’s levels, or (c) collapse below $30/bbl?  It is essential that you spend time debating these possible outcomes today, and planning how you would respond to them.

The key issue is that today’s oil market not being run for the benefit of people who actually use or produce oil.  The speculators couldn’t care less who does well, or who goes bankrupt, as a result of their activity.  They simply want to make the maximum amount of money for themselves, as quickly as possible.

Essentially, therefore, it is best to see today’s market as a very high stakes poker game.  And as any good poker player knows, “If you don’t know who is the fool at the table, then its probably you“.

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