Russia Will Not Cut Oil Production Now And RSX Will Head Lower

| About: VanEck Vectors (RSX)


Oil bounced on rumors about the possible coordinated supply cut between Russia and OPEC.

I explain why this will not happen in the first half of this year.

I share my views on the impact of the news on RSX and other Russia-related ETFs.

Lately, there was a lot of talk about the possible coordinated production cut by Saudi Arabia and Russia. The discussion started when Russia's Transneft chief Nikolai Tokarev told the press about possible talks between Russia and OPEC. The news had an immediate impact on the market and provided a boost to oil prices.

The following reports were skeptical. OPEC delegates stated there were no such plans. Russian Energy Minister Alexander Novak stated that cuts were possible only if all oil exporters would agree to cut production. Rosneft (OTC: OTC:RNFTF), Russia's leading oil producer, was the biggest skeptic.

Nevertheless, markets ignored all the negative commentary and focused on the possibility of a coordinated production cut. Both WTI (NYSE: USO) and Brent (NYSE: BNO) rallied; Brent's premium over WTI was restored. At the moment of writing this article, the spread between WTI and Brent was $2.65.

Not surprisingly, the original news and the consequent increase in oil prices had a major positive effect on Russia - focused ETFs, such as Market Vectors Russia (NYSE: RSX) and Direction Daily Russia Bull 3x ETF (NYSE: RUSL). Direction Daily Russia Bear 3x ETF (NYSE: RUSS) took a beating.

Before we proceed, a quick note on RUSL and RUSS. Similar to others 3x ETFs, a daily reset of positions significantly influences the ETF performance, and, at most times, their performance has little similar to the projected three-times leverage impact. In my opinion, if you don't use technical analysis and have little experience in short-term trading, you should not touch such ETFs.

Production cut talks and their impact on oil prices

I've previously argued that low oil is an existential threat to the Russian economic system. I am not predicting a sudden collapse, but I think that the more oil stays in the wide range of $25 - $40 per barrel, the worse it will get for the Russian economy.

Russian officials understand this threat. They also understand that while the oil price is on very low levels, any verbal intervention may trigger short covering. In my view, this is exactly what happened.

From the technical point of view, it's next to impossible for Russia to cut production in winter months. The well fluid has too much water which will freeze if the production is stopped. This could lead to a blowout - that's why repair works are conducted in warmer summer months.

In this light, the rally in oil will likely be short-lived. Once the short squeeze stops, the market will face the same oil glut as before. In my view, news that oil tankers have to cut speed as there is too much oil are highlighting the size of the oil glut problem.

As for Russia, the country will likely pump as much oil as it can. With Iran returning to the market, the battle for the market share will only intensify, and Russia cannot afford to step back in these conditions.

There has been a lot of debate within the country when the legacy fields' production will start to decline, but so far this did not happen and it looks like the country has at least several years of continuing production uptrend.

RSX: this is an opportunity to short the bounce

RSX gained more than 20% in recent days, but it underperformed compared to oil. The reason for this is that the ruble exchange rate returned to more "normal" valuations. As my loyal readers know, the topic of the ruble-denominated price of oil has been my favorite in the recent months.

As a quick reminder, the ruble-denominated price of oil is crucial for the Russian budget for this year. The budget was originally targeting 3150 RUB per barrel of oil, but looks to be realigning for a price of 2800 RUB per barrel. As oil drifted lower, the ruble-denominated price of oil dropped under 2300 per barrel as the Central Bank cut liquidity in order to support the ruble.

However, this relative strength could not have lasted forever, and the valuations returned to more normal levels as oil bounced from lows. As I'm writing this, the ruble-denominated price of oil is 2718 per barrel.

On January 29, the Central Bank decided to leave the key rate at 11%. The rate is still prohibitive for many economic agents, but the Central Bank has to deal with the weakening national currency. The odd thing is that the Central Bank still targets inflation of just 4% at the end of 2017.

In my view, there's nothing wrong with at 10% - 15% inflation if it is followed by economic growth. However, the Central Bank aims to curb inflation at any costs, which, in my opinion, endangers long-term economic potential of Russia.

I've previously written that there will be some point when RSX will diverge with the economy. I think that we are slowly approaching this point. My projections for the Russian economy are grim.

The tough investment climate together with the prohibitive interest rates kill the prospects for mid and small-sized businesses. I see no growth drivers unless oil flies to $100 per barrel. As an economy, Russia may be heading for a long time of stagnation if current market conditions persist.

However, it's RSX that you trade or invest in. RSX consists of bigger companies which will likely benefit from the death of their small and mid-sized counterparts. I think that this will be especially pronounced for retailers (Magnit is currently 7.74% of RSX holdings) and banks (Sberbank is 8.68% of holdings and VTB is 5.11% of holdings).

In short, I think that big will get bigger in the current situation, which may be a shield from the damage done by the shrinking size of the overall pie.

At the same time, if you want to short RSX, the time is now. The short squeeze was founded on a rumor, and, while it still might last for some time, the fundamentals will prevail. We are yet to see that U.S. production decrease will be bigger than additional output from Iran.

The recent oil price upside was a normal rebound given the size of the previous downside move. I remain bearish on oil and I think that the current oil price bottom will be retested.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in RSX over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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