Tuesday, February 16, 2016

The Real Goals Of Russia and Saudi Arabia's Deal

The newest talk over the oil-cooler (yes, I opened with that) in the offices' of hedge funds and investment banks is Russia, Saudi Arabia, Qatar, and Venezuela's new deal to freeze oil output at January production levels. The news prompted oil prices, both WTI and Brent contracts, to set single-day records for the gains at the end of last week. Despite prices rebounding above $30 (WTI) and $36 (Brent), the door closed at $29.04 and $33.48 a barrel respectively.

The deal between the oil producing giants brings a lot of ambivalent sentiment onto the trading floor. While a production freeze signals bullish news to commodity traders, the market will remain oversupplied at January output. The exact production numbers cited as January levels are as listed: Saudi Arabia at 10.2 million bbl a day, Russia at 10.9 million, Venezuela at 2.4 million, and Qatar at 680,000. The freeze didn't fool investors who saw it more as deceitful as large gains were pared to the smaller ones that are seen at closing. The numbers for Saudi Arabia and Russia are some of the highest they've ever posted. The deceitful announcement was established with three goals in mind: increase oil prices, retain market share, and decrease competition

Accompanying the officials from the four countries was Saudi oil minister al-Naimi attempting to augment the effect that the deal might have on oil prices. His words fell under the looming ghost of OPEC's dirty history. His endorsement slathered the outlook for oil fundamentals with the exaggerated enthusiasm for which OPEC's officials are famous. In Doha, al-Naimi cited the deal as the "beginning of a process" with hopes "to stabilize and improve the market." His hints at a follow-up might have been translated as a broader output cut conducted by the totality of OPEC member nations. The validity of such a statement is entirely in question with quotas assigned by the cartel often being ignored by its constituents. The oil minister continued to support the deal by saying that Saudia Arabia and Russia just wanted "to meet demand" and "a stable oil price." The demand comment struck me as curious. Even though the China Caixin Manufacturing Index rose to 48.4 last month, the indicator has been in contraction since March 2015, and the oil markets were oversupplied then! 


From TradingEconomics.com
Both Saudi Arabia and Russia knew that this deal would give U.S. producers a reason to hope as prices would no doubt rise sharply on this bullish news. With that knowledge, the countries involved with the deal intended to send a subtle message to those other producers while forcing their wills on the market. OPEC protocol typically demands a production cut or a quota that is anywhere from 2%-5% lower than current production. This play was certainly different. Freezing oil production allows the participants to establish a set production level that they know will allow them to stay competitive. At the same time, it gives the expectation of some retreat alongside an invite for other parties to come to the table because it's those producers who matter more at this moment. If the choice to pump or not pump oil is modeled by a game, one can say that Russia and Saudi Arabia took away the game of asymmetric information that leads to the producers' decisions to pump limitlessly. In place of that, other producers are given a choice with the knowledge of what Russia and Saudi Arabia will do in the future. With that knowledge, the individuals in the oil market can figure out how to maximize their own revenue, and clearly, cutting production achieves that goal. All the while, Russia and Saudi Arabia get to solidify their market share at record-level outputs and rising prices. How clever.

from Bloomberg

Closely related to the goal of maintaining market share, the last goal of the deal is a reduction of competition in the market. As the market continues to get more and more oversupplied, the blame for who is causing the glut has shifted over time. First, shale producers were blamed for their ascension in 2014 and incessant pumping into 2015. Over the course of 10 months, U.S. oil producers grew
 from 8,692,000 million bbl a day in June of 2014 to 9,701,000 in April of 2015, an 11.6% increase. By the middle of last year, their market share was established, and traders turned to the increases from OPEC production as to fault. When investors expected cuts, the cartel boosted their output from 30.77 million bbl a day in 2014 to 31.60 million bbl a day in 2015, an increase of almost 1 million bbl a day. Dissention between members in South America and Africa and their Middle Eastern companions heaped stress and uncertainty on the hopes for a deal. Oil prices then tanked going into 2016 as a divided cartel meant more competition in the global market for crude oil. The spotlight shifted one last time as a nuclear deal with Iran was developed and implemented taking away the sanctions that kept them from exporting oil. This deal addresses these smaller oil exporters (Iran and Iraq specifically who have political reasons for increasing production) and attempts to convince them to cut output. Some analysts are even citing the possibility of U.S. producers organizing a coordinated cut in order to make oil prices move higher. Essentially, Saudi Arabia and Russia have "thrown the ball in their court" enticing their competitors to back down with the potential profits of higher prices.

Is the oil rout finally at its end? Have we found a bottom for the troubled oil markets? The outcome of this deal remains unclear with the specter of dishonesty heavy in any deals concerning Russia and Saudi Arabia. Investors should continue to monitor the plans of Iran and other smaller Middle East countries to see if a coordinated cut could be organized. U.S. producers, on the other hand, will face an inevitable production drop as revenue levels remain low and pumps must close.

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