By Marco Cecconi and Gianluca Bertuzzo
Started in the second half of 2014, the drop in oil prices has been initially attributed to the oversupply derived by the American shale oil production.
According to EIA figures, throughout 2014, the American volume increased by c.16%, contributing for 57% of the worldwide oil production growth, which in turn, increased by 3.9% during the same period. The demand, which instead increased by only 2.5%, has not been able to absorb the imbalance causing a severe decline in the oil prices and, as a consequence, in the Mkt Caps of all the corporations strongly related to this commodity.
In January 20th 2016, the WTI crude oil price settled at its 12-year low: 26.14$ per barrel. The industry operators minimized the initial issues over the supply-side, claiming that the strike could have been determined by a reduction in the international consumption level, focusing in particular on the role played by the emerging markets (BRICS countries).
Opec, the most powerful cartel in the world
The Opec is a powerful organization composed by 13 Member Countries. It produces 41% of the world's oil volume and holds approximately 72% of the reserves discovered on earth (BP Statistical Review of World Energy 2015 Workbook).
Its mandate is to coordinate the policies of its Members ensuring the stabilization of the oil markets with the purpose to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair remuneration for those investing in the industry.
The Cartel's supreme authority is the "Conference", by means of which the topics of each meeting are discussed by the Members' delegations. Each Member has a voting right and the relevant decisions are taken only if unanimity is achieved. The "Conference" meets twice a year for the "Ordinary Meetings", even though "Extraordinary Meetings" could be declared in case of special requests.
This article aims to analyze the reaction experienced by the oil prices following a decision regarding the target level of production taken by the Cartel.
The target level of production is the lever employed to guide the oil prices towards wished and consistent values with the strategy pursued by the exporting countries. The analysis covers 17 years, from 1998 to 2015. In this span of time the "Conference" met 71 times, both in Ordinary and Extraordinary Meetings. The purposes of these meetings were to decide whether to: "Raise", "Cut" or don't change future production levels. Those choices have been analyzed by taking into consideration the prices context within which the Opec decided. For that reason, oil prices have been categorized into three bands:
1st band: from Min to 33rd Percentile 2nd band: from 33rd Percentile to 66th Percentile 3rd band: from 66th Percentile to Max
The statistical analysis used to identify the oil prices reactions to Opec's announcements is the Event Study Methodology. The reactions have been analyzed over a 20 days event window straddling the event in order to capture the short-term fluctuations before and after the announcements.
The graphs below shows the cumulative change in the Wti (NASDAQ:CAR) price in the event window straddling the official announcements regarding Opec target production.
The upcoming Opec meeting will be held on June 2nd in Vienna. Judging from the current situation, the most likely scenario in which the "Conference" will take the next decision, will be the oil prices in the second band, but close to the first one.
For that reason, the analysis' results will be focused on those two bands.
Historically, in the first and second band, the most frequent decision has been "no change": 46% of the times in the first band, 63% in the second one. The outcome, in terms of cumulated price change at the end of the event window analyzed is similar: 0% in the first case, -1.4% in the second one. Notwithstanding, the decisions to retain unchanged the supply have provoked different reactions in the days immediately following the event. In the first band, the Wti price, on average, increased and then fell back seven days after the announcement; in the other band, the Wti price remained substantially unchanged. This reaction could be explained by the fact that, by continuing the supply policy adopted in last meeting, the market is already in a position that balances (demand/supply) and any effect on the prices has been found.
Regarding the decision to cut the production, claimed with force over the last months by some Members as Venezuela ("Venezuela seeks support for oil production cuts", Financial Times, January 29 th 2016), a reaction in line with the expectations in the first band has been observed: the oil price increased on average by 4% in the 20 days surrounding the announcement.
On the other side, in the second band we experienced an unexpected average movement: the oil price fell by 6%.
From a deeper analysis, an outlier during the burst of the financial crisis has been found, which significantly affect the outcome.
By excluding such observation, the oil prices positively reacted to the "Cut" announcement. However, although the oil prices increased on average by c.1% at the end of the analyzed period, in the days within the event windows the market response is negative and in line with what has been seen with the outlier.
This situation could be determined by two factors: firstly the price could have been already incorporated the effects of a production cut; secondly the Cartel's announcements could be characterized by poor credibility.
Partial support to the second point comes from the general knowledge that the market is skeptical towards the Members' endorsement of their claims regarding the guidance provided. In fact, is it possible that the Cartel declared production reductions just to push prices higher in order to benefit from higher margins without reducing the effective level of oil sold. Such phenomenon has been observed in 2002, 2004, 2007 and in 2010, years in which, as a result of "Cut" announcements, the actual oil supply remained to the pre-"Cut" levels, or even, increased.
The aim of this article was to provide a model for the analysis and the interpretation of Opec decisions concerning the target level of production.
We think that neither the "raise", nor the "cut" decision will be taken, in spite of various rumors we have seen in the last months. Pressures made by some Opec Members, along with other external countries (heavily dependent on oil revenues), to cut the Cartel's level of production have escalated, even though in the last month they have stalled. However, this scenario appears less probable for the following reasons:
Lack of credibility of a production cut. The trustworthiness of the Cartel is doubted by many: according to data from different sources (BP, EIA) the actual Cartel production is exceeding by a significant amount the declared target of 30 MMbbl/d (as shown in graph X). Furthermore, we could also look at past behaviors: in the months following the announcement, the effective production is even "surprisingly" increased. This "fraudulent" way of dealing with "not sticking to the policy" after a production cut could be explained by opportunistic reasons: each Member Country tries to exploit the opportunity to obtain higher profits through the increase of production in a context in which the oil price is expected to rise. Nevertheless, market operators seem to have recognized this phenomena leading to an oil price reductions (on average) after the announcement of a production cut. Moreover, a production cut is not coherent with the strategy to secure the Cartel the current market share gained during the years: either force out high-cost producers or make other energy sources (i.e. renewable) uneconomic in comparison with oil. Although those players have resisted for more than one year, several indicators have been signaling a progressively exit from the game. Let us list, as the most powerful, the following:
- High Yield (spread) curve
- Number and Volume of defaults
- Rig count
A move that theoretically should push the prices higher would be nonsense considering the strategy upon mentioned: demand and supply would be back in equilibrium not for an economically fair exit of high-cost producers, but for an arbitrary decision of the Cartel.
It is also unlikely an increase in the target production which would result in a deterioration of an already difficult balance sheets situation for several Members.
In light of the above reasoning, the "No change" seems the most likely decision the Opec will take. Such a conclusion is supported even by recent declarations over an eventual agreement regarding a production freeze between Saudi Arabia (the most politically influential Member of the Cartel) and Russia.
Considering the scenario delineated, we suggest for any investors willing to take high risk-return profiles, the following investment strategy:
- Series of straddles on Wti/Brent until one week before the announcement;
- Long Wti/Brent one week before, until one day before, the announcement;
- Short Wti/Brent the night before the announcement until the following two weeks;
The first operation would benefit from the volatility we project as leading factor until the announcement;
The second one would profit from the speculation over the decision wanted by the market: "Production cut", that will probably push the price higher for some days;
Finally, the third operation would gain from the downside scenario if the "No change" actually occurred , as happened in the past qualitatively and quantitatively.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.