I've been short oil on and off for over a year now, and there has been a lot of hype around the meeting of some OPEC countries with Russia, a non-OPEC member on Tuesday. While this may be seen as a break-through in the long run, in the short run, this "deal" changes absolutely nothing. While several countries signed, Iran, Iraq and Libya were left out.
A deal? What deal?
And these three countries is where the extra supply can (and will) come from while the countries that signed the deal have practically "legalized" the maximum available production they are currently able to pump out. These countries were currently running at peak sustainable levels (arguably over them), so this deal will cost them absolutely nothing. The deal is not enforceable, not trackable, and is conditioned on "other major oil producers" to freeze production at current levels. This is an illusion, not a deal offer.
A token of superficial goodwill
The "deal" is just a token of goodwill to address the repeated demands of some OPEC countries, notably Venezuela, to do something for it as a fellow OPEC member. In reality, Saudi Arabia probably couldn't care less about Venezuela's fate. It is only a non-Arab OPEC member and is half a world away. Politically, it is a Marxist experiment. So there is very little in common interest for these two countries to have any lasting relationship. Perhaps having an authoritarian regime is the only common ground. And many signs, such as normalizing subsidies, plans to privatize companies, including non-core parts of Saudi Aramco, and open access to foreign investors to the stock exchange are pointing to Saudi Arabia steering away from the authoritarian nature and closer to a more diversified, market-driven economy.
Russia has been a long-time supporter of Venezuela due to the common Marxist/socialist ground, so Russia also doesn't want to look like it has abandoned its "friend" in harsh times. However, same as in the case of Saudi Arabia, there is very little common interest for these two countries. They are too far away from each other geographically. Moreover, they compete for the same global oil market with their oil exports.
A weak Venezuela is a good Venezuela for Saudi Arabia and Russia
So in the long run, a disintegrated Venezuela is in the best interest of Saudi Arabia as Venezuela is a big long-term rival of Saudi Arabia due to Venezuela having one of the highest oil reserves in the world. In fact, some sources put Venezuela's proven reserves at the highest in the world, just ahead of Saudi Arabia itself.
Venezuela is now truly at the verge of a total collapse. The country's credit rating has been cut to junk or downgraded further just a few days ago by the S&P and Moody's rating agencies. Some current estimates put the inflation rate at over 200% annualized. This is a total destruction of value and savings, a true hyperinflation. And the IMF forecasts inflation to hit 720% this year. That's a total collapse and a marked worsening of the situation, even from the current dire levels.
Add to that a serious Zika virus outbreak that puts strains on its healthcare system while a revolution is happening in the streets as we speak and the country is sliding into an abyss. A Google image search for "Venezuela situation" tells the story better than my words. There are shortages of basic goods (especially foreign-made).
So for Venezuela, which desperately asked for coordinated production cuts that would have immediate effects on the prices, the Saudi-Russia "deal" was like throwing a beggar on the street a dime. It doesn't help the person at all but it makes them (Russia and Saudi Arabia) look like a good person and it relieves them of some bad conscience about the beggar's situation. As a disclaimer, please note I'm not saying at all that Venezuela should or should not be helped under the current authoritarian regime, just analyzing the situation the oil market is in. I focus on the markets, not politics.
Russia and Saudi Arabia are just trying to outsmart other oil producers
So back to the "deal." If anything, this deal tells me that Saudi Arabia is in for the long run, willing to keep the oil prices low for as long as is needed for the global oil output to really fall. If anything, Russia and Saudi Arabia are trying to outsmart the other OPEC members by proposing a "freeze" at a time when these two countries are at their absolute peak production levels (some would argue beyond technically sustainable levels in the long run) while other OPEC members are still far from their potential and are just returning to the official (legal) market (Iran, Iraq, and Syria). The real story to watch is that Iran sends its first shipment abroad since the sanctions ended. The real oversupply on the ground just worsened.
Are Russia and Saudi Arabia playing each other?
Additionally, Saudi Arabia and Russia are not exactly best friends. They may be in this deal proposal just to ease tensions and remain open to future negotiations. Oil and the Middle East conflict is interrelated, and an oil cut by either Russia or Saudi Arabia may be offered in the future as part of a negotiating package in the Syrian conflict resolution and Iran negotiations. Russia currently seems to support both of these regimes while Saudi Arabia seems to be on the other side. So again, very little common ground here.
The oil oversupply continues and will continue
The oil oversupply could hit roughly 1.5 million barrels a day during this quarter according to many sources, including the IEA. And it is not only the current official oversupply and the threat of further production increases of Iran, Iraq and Syria that are looming over the oil markets, but it's also about the buffer reserves that are already stored in the system. Almost every reasonably large country in the world has several months' worth of import demand in strategic oil reserves. Many countries are using the current low prices to increase these reserves. China is an example. Its official reserves have doubled in just eight months in 2015 to 190 million barrels.
One-time demand boosts from strategic reserves buildup
So China alone ordered ~95M barrels of oil in 2015 to boost its reserves, not to consume. And yet the world is oversupplied by ~1.5M barrels per day. What happens when this one-time boost of "demand" which is just shifting oil from one place to another, and not consuming it, stops? If China alone didn't increase its reserves in 2015, the oversupply would have been higher by more than 0.3M barrels per day. And this is just China's reserves. So part of the oil production marked as "demand" was actually just put back into the ground as a one-time strategic reserve buildup.
China plans to hold much more in reserves, as much as 550M barrels of oil by 2020. So its one-time "demand" will probably last for several years if the oil price remains low. This strategic "demand" from other countries will probably last as well for a year or two as long as oil prices remain low. But, if oil rises too much, countries are likely to slow down the buildup of these reserves, reducing this part of the oil demand.
The hidden U.S. reserves
What would you call a roughly 500M barrels of oil stored in the ground by U.S. oil producers in the form of drilled but unfinished wells? I call it a huge hidden storage. And a very cheap storage compared to alternatives. Shale companies can safely sell oil futures or options on futures on these reserves and reap the massive contango benefits (and also time value in the case of options), massively improving their cash break-even points.
In any case, this hidden reserve will very likely hit the market as soon as prices rebound or if contango decreases to low levels. Even if oil prices don't rebound, some companies will still be forced to extract these hidden reserves in order to pay interest and debt.
This hidden ~500M U.S. storage alone would need roughly a year to clear if oil supply-demand shortage was 2M barrels of oil per day. The world's current supply-demand surplus is at roughly 1.5M barrels of oil, and there are risks the supply will rise further (Iran, Iraq, and Syria). At current global supply fall and demand growth, it will probably take more than a year for the situation to resemble anything close to a tight supply-demand market on a daily basis. And even then, there will be a huge overhang of hidden U.S. reserves from unfinished U.S. wells which would take roughly two years to completely clear at 1M barrels of daily incremental production.
Strategic reserves can be strategically sold as well
Moreover, globally, there is roughly 4.1B barrels of oil stored in strategic reserves, of which ~1.4B is government-controlled. A lot of it is truly strategic reserves and would not be sold, but futures contracts can still be sold on part of this storage, especially the private part, if holders would be willing to sell this part of the reserve at higher prices. This and the futures sales made on the U.S. unfinished well reserve are putting enormous pressure on the entire futures prices curve as well as the spot oil prices.
In any case, the reserves represent a huge buffer of supply even after the supply-demand equation flips to a situation where the daily demand outstrips the daily supply.
The low supply-demand imbalance focus that ignores the huge stored oil reserves reminds me of the low U.S. unemployment rate that ignores the large reserve of those who gave up trying or settled for inferior jobs. In both cases, the "supply" overhang is huge and will take many years to clear. Incidentally, in both cases, there will be deflationary pressures from these effects.
The real oil oversupply is huge when hidden and commercial reserves are included. This reserve can absorb rising demand for many years. The Russia-Saudi Arabia "deal" is just a token of superficial goodwill toward Venezuela and other OPEC members that asked for cuts. The "deal" is just an offer to freeze production, not cut it, and even that only if others agree to cut as well.
At peak Russian and Saudi Arabian production as opposed to restrained output of several other OPEC producers, the deal is unlikely to be accepted by those OPEC and non-OPEC producers whose production is currently expected to rise the most. The deal offer is unlikely to have any fundamental effects on the oil imbalance because it only offers to cap production and not to cut it. The likelihood of any meaningful deal happening is low due to a very different output situation among OPEC members and their disparage interests. Independent U.S. producers also are very unlikely to agree on any cuts. Even if a deal happens, the global private and public reserve of oil would keep a lid on oil prices for years.
Oil futures remain in steep contango. This gives oil producers and hedgers in oil futures or their ETPs, such as the United States Oil ETF (NYSEARCA:USO) or the ProShares Ultra Bloomberg Crude Oil ETF (NYSEARCA:UCO), an additional incentive to keep shorting. I remain short oil futures as a hedge of long stock exposure despite the massive gains this trade has delivered in the past year. The risk/reward is not as good as before but still very reasonable, even when accounting for the black swan event that all major producers agree on a large enough enforceable oil output cut. The daily deficit would take a long time to reduce the total oil reserves in the system.
Disclosure: I am/we are short USO.
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.