OPEC Talks a Good Game

The way prices are moving will challenge producers.

Perception is reality. That is how Qatar's Minister of Energy could have kicked off the letter inviting his Norwegian counterpart 1 to the upcoming freeze-fest in Doha, which Bloomberg published  on Thursday. In the letter, the minister claimed that mere talk of a freeze had "changed the sentiment of the oil market."

He's right.

Brent crude has rallied by almost 40 percent since the idea of an output freeze first surfaced in February. Despite very mixed signals about it from Saudi Arabia, Iran and others, this has been enough to scare the short-sellers straight.

Doing the Job

Brent crude oil price

Source: Bloomberg

The question for investors heading into the weekend is whether Doha's conclave can keep the oil bears cowed.

To do that, the producers will need to deliver a very strong and credible message, in part because of what they have achieved already. You can see below how the recent price rally coincided with hedge funds hurriedly unwinding bearish oil bets.

A Short Story

Non-commercial long and short positions in oil versus the price, indexed

Source: Bloomberg

Having done this, though, speculators' net position in the oil market is now around the most bullish it has been in almost a year.

The Long Game

Non-commercial net length in WTI crude oil versus the price, indexed

Source: Bloomberg

The shock of the freeze worked earlier this year partly because sentiment was already so negative. That isn't the case now. The consensus view is that Sunday's meeting won't achieve much in terms of concrete changes to supply, and that in itself sets up the potential for a bullish surprise. Still, looking at that chart, it is going to take something quite unexpected, and deftly worded, to come out of Doha to encourage much higher bids.

The rally has also made it harder for speculators to mop up excess supply by putting it into storage and selling it forward. I explained here how this carry trade had been squeezed in the Brent crude futures market. The WTI crude oil curve hasn't shifted quite as much -- but the implied return on the carry trade even there has also been wiped out.

Carried Out

Implied annualized return on buying physical WTI crude and selling six months forward

Source: PKVerleger LLC, Bloomberg, Bloomberg Gadfly analysis

Note: Assumes 80 percent borrowed at Libor plus 100 bp and monthly storage cost of $0.60 per barrel.

One reason the carry trade is losing its allure is that longer-dated oil futures haven't rallied as quickly as near-dated prices. One reason could be that oil and gas producers, especially struggling U.S. independent firms, have been selling future output to lock in cash flow.

Notice how short interest on the part of oil producers and merchants has kept climbing while prices have fallen. Back in the summer of 2014, before the cataclysm struck, few wanted to miss out on the upside by locking in forward prices. Now, as gaining assurance on cash flow has become a priority, short interest has shot up even as prices have slumped.

Crash is King

Short position of WTI crude oil producers and merchants versus the rolling 12-month futures price, indexed

Source: Bloomberg

Of course, any succor that E&P companies gain detracts from the ultimate rebalancing of supply and demand required for a sustainable rally. In that sense, the rhetoric around Doha has a counter-productive side effect. While surplus production is coming down, as noted in the International Energy Agency's monthly report released on Thursday, the process remains slow and uncertain.

The IEA report showed that OPEC production has actually dropped by about 250,000 barrels a day since January, the supposed reference month for the freeze. Let's be generous and assume that a freeze takes hold at current levels instead (and let's include Russia as freezer). Assume also that wildcards Iran and Libya -- both aiming to raise output -- remain stuck, either by choice or not. On that basis, and using the IEA's projections for global demand and non-OPEC supply outside of Russia, we swing decisively from surplus to deficit in the second half of 2016.

The Flipside

Implied surplus/deficit of global oil supply, assuming Russia and OPEC freeze at current levels

Source: International Energy Agency, Bloomberg Gadfly analysis

That scenario is what oil bulls are banking on to keep sentiment shifting in their favor and extending the rally. But two obstacles may get in the way of that playing out.

First, it doesn't take account of the excess supply that has already built up. Secondly, Iran and Libya may well succeed in raising output. The chart below shows OECD oil inventories relative to forward demand, assuming that all excess oil flows into Iran and Libya and back out when there's a deficit. You can see that, even if Iran and Libya get stuck, draining the tanks won't happen overnight.

A Fine Balance

Implied commercial oil inventories in the OECD relative to forward demand

Source: International Energy Agency, Bloomberg Gadfly analysis

Note: 'Iran/Libya Increase' scenario assumes each country raises output by 300,000 barrels a day between 2Q and 4Q 2016.

The upshot is that maintaining momentum in the rally after the Doha meeting isn't impossible, but it still looks very difficult. And producers must be careful not to derail the main benefits of low prices from their perspective: boosting demand and reducing non-OPEC supply, particularly in the U.S. It is risky to raise price expectations in a competitive market.

It may be that involuntary supply cuts end up doing the job for the freeze crowd; Schlumberger's decision this week to pare back services in Venezuela due to non-payment was another reminder of the damage cheap oil is doing to some fragile petro-economies. Barring that, though, OPEC's best hope may lie in getting Doha out of the way and then talking up the prospects for yet more "action" at its next meeting in June.

((Corrects the date of the Doha meeting to Sunday from Monday.))
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. He declined (respectfully, one imagines.)

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net

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