Understanding the Crude Oil Short Squeeze

Wow…

I never thought I’d be writing this note today. But, that’s the financial markets business for you.

Financial markets are always surprising, and never forgiving. One shock move can make or break your portfolio. For that reason, it’s always important to hope for the best and plan for the worst. Remember, investors and traders can’t always be right.

The real question is: how do you know when you’re wrong?

I always recommend using stop losses. They draw the line in the sand, showing you when you’re right or wrong. If you get stopped out, you are wrong.

Stop losses would have come in handy for many investors last week. The majority went short crude oil heading into the OPEC meeting, especially when Saudi Arabia said it wouldn’t attend the talks. The crude price fell to below US$45 per barrel on that news.

Surprisingly, as you probably heard, OPEC stuck to its word and agreed to cut production. What followed was the biggest short squeeze since 2009. So, what’s next?

I’ll analyse the story…

The deal

OPEC agreed to cut 1.2 million barrels of oil per day (MMBOPD) from the market last Wednesday. The decision triggered a massive short squeeze (traders getting stopped out and switching their positions to the long side), sending crude prices through the roof. Check out the chart below:


Source: Bloomberg
Click to enlarge

West Texas Intermediate (WTI) futures — the US crude oil price — surged 12.2% for the week, to $51.68 per barrel. The five-day gain was the best weekly performance since February, 2011. Brent crude futures — the international oil price, associated mostly with OPEC — surged 15% for the week to $54.35 per barrel.

OPEC said it would cap its production at 32.5 MMBOPD. You can see the impact on the chart below:


Source: Oilprice.com
Click to enlarge

The ‘cut’ should be effective from January and last for six months. It seems like a great deal…for OPEC.

OPEC normally cuts supply heading into the northern hemisphere winter months (December to February). That’s when demand pulls back on a seasonal basis. In that case, it’s not doing anything it wouldn’t normally do. When the organisation cuts production next year, it will still produce more crude than it did in 2015 — a year when crude prices were in freefall.

A lot of mainstream analysts and commentators have missed that point. But that’s not all.

Remember, the deal should conveniently last for six months. In other words, not only will the organisation pump out more crude during the coming winter months, OPEC can ramp up production during the seasonally high-demand Northern Hemisphere summer months. Stockpiling tends to surge during the summer, to prepare for the cold winter months.

This is an absolute disaster for the demand-supply balance.

And, alongside the OPEC production cut, non-OPEC members (mainly Russia) should gain the same benefit. Non-OPEC members are on track to reduce production by 600 MBOPD. The Guardian reported on 3 December:

Russia, which is not an Opec member and produces about as much oil as Saudi Arabia, counts as a further reason for caution. It is supposed to be part of the new arrangement, and officials in Moscow are scheduled to announce production cuts next week. The press conference is likely to go ahead, but analysts are sceptical there will be a significant move to cut production when oil revenues make up most of the Russian government’s income.

Given the recent happenings, I’m quietly confident that a Russian deal will take place next week.

Enforcing the deal, however, is a different matter…

The countries can cheat, delay the deal, put out fraudulent numbers, or even call the deal off at the last minute. So, with plenty that could happen, what’s next?

Focus on the facts

The organisation’s shock news is still being factored into the market. Despite popular economic ‘wisdom’, this won’t happen instantaneously. Financial markets aren’t efficient in the real world — assets are often mispriced.

In crude oil’s case, with some reservations on the implementation side, the deal is done. That’s bullish for the short term. The trend in motion should stay in motion…at least temporarily.

OPEC should have less influence on the crude market heading into early next year. There’s no need to wonder if the organisation will cut or not.

The deal is done.

Fundamentally, despite the potential for some volatility, US crude oil could surge into — at least — the OPEC-non-OPEC meeting on December 9. Technically, WTI crude could hit the US$55 per barrel resistance level. For that to happen, it must close above US$52.22 per barrel — this year’s high — on a daily basis.

Does this mean that the crude bull is back?

Perhaps. But, that’s a story for another day. I’ll share it with Resource Speculator readers next year. There’s a lot to talk about. It’s a complex story, which requires analysing the final details and removing the emotional bias.

I’ll keep you updated on this story. Stay tuned!

Regards,

Jason Stevenson,
Resources Analyst, Money Morning


Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read. Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.


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