Oil Prices, Volatility, And OPEC

by: Osama Rizvi

Oil prices have rallied more than 30 percent this year. However, and as we have observed, the rally might not last.

One of the most important factors that will decide the trajectory of oil prices is the OPEC production cuts.

Venezuelan crisis and rhetoric between Iran and U.S. might help to add a few dollars from the current price levels; however, as June approaches, nigh oil will start to fall again.

Oil prices have seen a whopping 30 percent increase this year with a recent sharp hike as Trump administration canceled waivers given to countries to import Iranian crude. Other factors such as an unfolding crisis in Venezuela, OPEC's production cuts and war in Libya have also helped. However, the rally may not last for a longer term.

Markets are abuzz with news lately. Bulls were right to point out a rally citing cancellation of Iranian waivers as a reason. But so were the bears when they questioned the durability of that rally with prices having already retreated. At the time of writing, WTI is hovering around $62 and Brent is playing with $71. Bets are on whether both will retain some support and remain range bound or fall below the crucial levels of $60 and $70 for WTI and Brent respectively.

To answer this question, we have to look at one of the most important factors that is OPEC production. The cartel will meet in June to decide whether it will increase production or not. Recently, the compliance rate has jumped to 155 percent as OPEC members, especially KSA (Kingdom of Saudi Arabia), have squeezed more output than promised. In April 2019, OPEC's production fell to four year's low at 30.23 mbpd.

But Trump is adamant that OPEC should increase production, however, KSA, the de-factor leader, needs to fill in its budget gap which, at 4.2 percent, is not dangerous but still important. Traders and market observers may look at the question of production increase in two ways.

Imagine a scenario: OPEC meet in June and decide for a production increase (that is not to say to end the production cuts agreement currently in place - doing so can result in another oil price crash) to offset the lost barrels from Iran. Evidently, we will see oil prices falling down as those who worry for a supply shock will take a sigh and stop biting their nails. However, there is another way to interpret the above: consider "spare capacity" which can be defined as "the volume of production that can be brought on within 30 days and sustained for at least 90 days", and according to EIA, Kingdom of Saudi Arabia (KSA) has the greatest spare capacity as of today - around 1.5 to 2 million barrels per day. If and when KSA increase production, this can also be read as a sign of worry due to the fact that KSA will already be using a part of the spare capacity affecting its faculty to act in case of emergency.

With Venezuelan and Iranian sanctions in place plus the brewing war in Libya and aggressive rhetoric from Iranian Supreme Leader, the overall scenario will be easily cashed in by traders and speculators to instigate fears and then gloat on them. So, it turns out that production cuts can go both ways. It all depends upon the collective mindset and reaction at that time which is going to drive the sentiments in either direction.

Oil to remain range bound before the meeting

What can we expect before OPEC's June meeting? The safest bet is that oil prices will remain range bound and we might not see a steep rise or fall in prices. The chances of prices rising from current levels get more strength when we take a stock of recent developments in Venezuela where efforts to topple Maduro are gaining momentum. In case the army turns against the incumbent president and there is indeed a coup de grace, then the ensuing uncertainty will definitely result in another price hike due to reasons pertaining to supply.

But then, at the other end of the spectrum is the prospect of OPEC increasing production and there are already rumors that this will happen. We have discussed two possible scenarios that may rise as a result of OPEC production increase. However, if one read between the lines, there are chances that the concerns regarding "spare capacity" will be allayed as markets realize that there is enough supply in the world - see the recent inventory build-ups.

Buy and then Sell

The current price level is a little hard to decode in that the direction of the market is not quite clear (it never is). However, it is safe to buy from this point, take $2-3 maximum gain and then take a selling position. Oil is hovering at $62 right now. We can buy from here and see if the resistance level of $63.40. If it breaks the level, the maximum it may touch is $66 or something around that (as it did previously), but this will be in case of a very bullish news such as KSA to uphold the current production levels or trade war coming to an end (recent news show that it might not happen anytime soon).

Any level above $65 would be a good point to start accumulating barrels for selling. It already touched lower $60. Once again, we can expect that from the height of $65, $66 (if and when it goes there), a selling position can give a good $4-5 gain to the trader.

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.