When the OPEC cartel decided to cut output for the first six months of 2017 back in November 2016 it sparked a rally in oil prices. Now the Cartel is trying to repeat the trick. In this analysis we take a look at how this deal has been executed, how fundamentals of the oil market changed and present 4 trading scenarios for the OPEC meeting on 25 May.

OPEC presented unusual discipline

The deal assumed a cut of more than 1.7 million barrels per day (mbd) and it must be stressed that the OPEC showed an unusual discipline in execution. Among the Cartel members only Iraq, Angola and Algeria missed their targets slightly, while Saudi Arabia and UAE exceeded their obligations significantly. The non-OPEC countries that joined the deal showed less discipline with Russia missing the target and Kazakhstan and Malaysia actually increasing output. Overall, the deal execution has been very  solid and this has helped oil prices. However, many factors have turned in a negative way for the OPEC and oil prices.   

 OPEC countries showed an impressive discipline in deal execution, but that was not enough to balance the market. Source: Bloomberg

Why are we fundamentally bearish on the oil market?

• US output increased much higher than anticipated. It exceeded 9 mbd in the first quarter while the OPEC projected only 8.8 mbd. A surging number of drilling rigs herald further increase in production. Marginal cost for shale produced is estimated at below $40/b compared with above $55/b two years ago.
• Libya and Nigeria were not covered by the deal and they increased their output, further eroding effectiveness of the cut. Including those two countries, the deal execution drops from 100% to below 70%.
• Demand for oil products seems to be softening and it may be the case for China, India or even the US.
• While US inventories have declined recently, the “2017 inventory path” is still record high. The OPEC hoped that a 6-month deal would normalise inventories now it’s obvious that even another 9 months of the cuts might not suffice.

  

   US oil inventories remain excessively high. Source: Bloomberg, XTB Research

• Speculative traders on the oil market remain net long, actually more aggressively than ahead of the last OPEC meeting. This could limit the upside and increase room for a disappointment.  

4 OPEC trading scenarios

Fundamental outlook for the oil market might not be bullish but a short term price dynamics will depend heavily on the outcome of Thursday’s meeting. Here we present 4 possibilities and related trading strategies:

Deal extension for 9 months – the OPEC decided to cut output by 1.164 mbd for the first quarter of 2017 and non-OPEC countries pledged another 0.558mbd. A simple extension of these cuts by as many as 9 months (to avoid seasonal oil surplus in Q1’18) has become the market consensus and has been broadly priced in. In such scenario we could still see some short term upward movement but traders could consider selling the key resistance around $55 for WTI barrel, targeting a return below $50 as market positioning is skewed to the long side and oil balance could not improve as much as OPEC hopes.

The OPEC could find it hard to take WTI prices above $55 for a longer period. This key resistance could be a good selling point unless the deal beats market expectations substantially. Source: xStation5  

Deal extension for 6 months – when it became obvious that the first OPEC deal was insufficient to restore market balance, the Cartels’ representatives hinted at a 6 months extension. However that would expose prices to a surplus at the beginning of 2018 when a seasonal demand is lower and US production could top 10 mbd. Therefore a simple replication of November’s deal would be seen as a disappointment and could lead to declines in oil prices. In such case traders could consider selling OIL.WTI at market with a target of $45. A similar strategy could work if the deal is extended (even for 9 months) without some non-OPEC countries, especially Russia.

Production  cuts in excess of 2 mbd or/and beyond 9 months – while the Cartel realises that any deal transfers market share away, it has no choice, so why not to go bold? Even temporarily higher prices would provide a relief for strained budgets. While an aggressive deal assuming cuts of at least 2 mbd for at least 9 months could be hard to execute, a short term rally would be very likely. Traders could consider buying OIL.WTI at market targeting $60.

No deal – this seems to be the least likely scenario. The OPEC must realise that without cuts oil surplus would quickly weigh on prices. While unlikely, this scenario is not entirely impossible and should it materialize, traders could consider selling OIL.WTI all the way down to $38.