Unpacking The Saudi Bluffing Game

Includes: OIL, USO
by: MTS Insights


West Texas Intermediate and Brent spot prices have fallen into a short-term bearish trend, after reaching highs in the $40s this year.

The short-term trend is a result of investors becoming less convinced that an output freeze is possible.

Both past and present geopolitical and economic tensions endanger the output freeze that Saudi Arabia hopes to push onto OPEC members in Doha later this month.

The bulls were back supporting oil again, as its price ran up past $40 a barrel in the past week after expectations of a release in supply pressure looked to be a real possibility. Saudi Arabia showed the first signs of relenting, when they signed an agreement with Qatar to freeze petroleum output at a certain level. Other members of OPEC have shown less enthusiasm towards the freeze that would only be effective if all exporters were on the same page. New bearish reports now fuel skepticism that this agreement will materialize, as Russia pumps at a 30-year high of 10.91 million b/d and Iran's oil minister insists his country will continue to increase production.

In response, investors have traded WTI and Brent lower, with losses of -7.96% and -7.34% seen over the past five trading sessions. Money managers partook in the reversal, and regulatory data from the CFTC showed a 6.3% net reduction in their long positions last Friday. The chart above shows a resumption of a long-term downtrend that ended in the beginning of February. The "momentum accumulation" shows the net number of gaining sessions and losing sessions over the past 100 days. After the fresh pessimism on the part of traders, the count now sits at -20, or 20 more losing sessions than gaining sessions. Technicals-based bears might also note that last Tuesday, the WTI spot price fell below a 100-day moving average. The question now looms: Will the bottom be revisited? Regardless of the future, current headlines stay covered in black gold.

The optimistic trading was mostly caused by prospects of a broad output freeze, scheduled to be discussed in Doha, Qatar later this month. The leader of OPEC will attempt to convince producers, both member and non-member, state and private, to support the price of oil by curbing increases in output this year. After sanctions on Iran were lifted late last year, the government threw open the spigot with a production of 3.1 million b/d and rising. The Energy Information Agency (EIA) estimates that this represents a jump of about 300,000 b/d of production in 2015, with another 500,000 b/d to be added this year. Russia's recent high in output also threatens to prolong the saturation on the supply side of the market, and might become a point of contention at the round table in Doha.

The oil cartel has developed solutions to the low oil price situation in the past, with Saudi Arabia at the helm. The collective goal of maintaining an iron grip on the energy market has helped the quota agreements to pass easily, with only minor deviations from OPEC members. This time around, two major constituents, Saudi Arabia and Iran, might spoil the very freeze that they desire. The previously sanctioned country has been attempting to expand its exporting infrastructure to its pre-sanction size, which includes the launching of new oil tankers and transportation through SUMED, the Arab Petroleum Pipeline Company, to the Mediterranean Sea. Reports from RT and The Wall Street Journal describe a Saudi campaign to restrain an Iranian comeback on both fronts. The efforts to curb exports have limited Iran to transporting just 12 million barrels of oil to Europe - just over a week's worth of production.

Antagonizing a country's crude oil output just before asking them to freeze it as a favor is a perplexing diplomatic maneuver. The move may have implications beyond the energy arena, considering the longstanding rivalry between the nations that transcend oil tankers and production quotas. Iran and Saudi Arabia are as different as Middle Eastern countries can be. While both are Islamic nations, one is ethnically Arab, speaks Arabic, and follows the Sunni sect of Islam. The other is Persian, speaks Farsi, and subscribes to the opposite sect of Islam, Shia. The history of geopolitical tension between Iran, Saudi Arabia, and the Western nations complicates the meeting that is scheduled for late this month.

Something tells me that this freeze was doomed from the first time it was mentioned by the Saudi oil minister. OPEC just recently hit their highest levels of production in 2015 without Iran operating at full steam. For that reason, Riyadh has been able to take advantage of the extra market share and line their coffers with revenue at higher prices. Fast-forward to the beginning of 2016, where prices are a fraction of what they used to be, and Iran has just had their sanctions lifted. Any struggling country in this situation would tap into their best source of revenue where they maintain a healthy comparative advantage and an extensive infrastructure with workers, plants, and equipment waiting to produce. Iran is no different, and their capacity to pump twice of what they are currently producing is that necessary cash flow. I don't think investors, non-member producers, and Saudi Arabia should be counting on a freeze to relieve the supply pressure on prices. I also think Riyadh knew this.

There have been reports that say OPEC officials think a deal without Iran would still have a significant impact on the fundamentals of the oil market, but I do not think that to be the case. Global oversupply runs at about 1 million b/d, with non-member production expected to cut that in half. Iranian output increases alone could completely offset this potential balance or make the market even more saturated. Whether or not the Saudi government actually believes Iran would be unnecessary in a freeze agreement, or that hindering Iran's oil exports is a good diplomatic idea, seems irrelevant, because the freeze was improbable at introduction. Instead, the idea of a freeze could have been conjured up as a way to manipulate investor expectations in the hope of spurring a rebound in the price of oil. OPEC has a history of pushing perceptions in their favor.

Predictions? Just that $40 a barrel prices might be out of reach for a while. The current trend of investor sentiment will only be able to support prices in the mid- to high-$30s until more bearishness is seen in the event of a failed summit in Doha. For now, though, investors aren't buying the Saudis' assurance of an output freeze.

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. I have no business relationship with any company whose stock is mentioned in this article.

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