OPEC nears decision time: rollover or deepen cuts? Kemp
OPEC ministers head to Vienna next week where they are expected to ratify an extension of the current production cuts that has been agreed informally among the key participants.
Saudi Arabia and Russia announced earlier this week that they have agreed on the need to extend OPEC and non-OPEC output cuts for a further nine months until March 2018.
Riyadh and Moscow pledged the bulk of cuts under the current agreement between OPEC and non-OPEC exporters so their agreement on the need for an extension has made an extension very likely when OPEC meets formally next week.
Other OPEC ministers have already signalled support. Crucially both Iraq and Iran have stated they are in favour, which removes any remaining obstacles.
In theory, OPEC could try to surprise the market by announcing deeper cuts or an even longer extension beyond March 2018, though most analysts and traders have discounted the possibility.
Saudi Arabia and Russia left the door open by promising “to do whatever it takes to achieve the desired goal of stabilising the market and reducing commercial oil inventories to their 5-year average”.
Past experience suggests a decision to deepen the cuts would cause a sharp increase in prices in the days following the announcement but an extension would have little impact or cause prices to fall slightly.
Researchers have studied the impact on oil prices of all OPEC decisions between 1983 and 2008 (“The behaviour of crude oil spot and futures prices around OPEC and SPR announcements”, Demirer and Kutan, 2010).
They found that OPEC decisions to cut production caused prices to rise significantly over the following month, but decisions to rollover an existing agreement caused prices to fall slightly.
“The degree of return persistence following OPEC production cut announcements creates substantial excess returns to investors who take long positions on the day following the end of OPEC conferences,” according to Demirer and Kutan.
The authors estimated excess returns on a long position to be around 7.5 percent for the front-month futures contract and 4.5 percent for the 12th-month contract over the course of the following month.
In the build up to most OPEC meetings, crude traders’ default assumption seems to have been that OPEC would struggle to reach an agreement on cutting production and would normally take the easier course of extending existing allocations.
Decisions to cut production therefore tended to surprise the market and push prices higher, but a rollover was mostly anticipated and had little impact on prices.
Prior to an OPEC meeting, traders have usually assumed there is a small but non-zero chance output will be cut, and a larger probability that allocations will be rolled over.
Oil prices have reflected these ex ante estimates of the probability of output cuts versus the probability of a production rollover.
In the event that the meeting agreed on a rollover, the relatively low ex ante probability of output cuts declined to zero ex post, and oil prices adjusted downwards slightly.
But if the meeting decided on a reduction, the ex ante probability, usually seen as low, suddenly rose to 100 percent ex post, and the surprise factor drove prices higher.
“The market is not sure what the outcome will be: Will OPEC cut production or maintain the status quo?” according to Demirer and Kutan. “If OPEC announces a production cut, the surprise leads to an upward adjustment in prices.”
“However, if OPEC maintains the status quo, the market takes this inaction as a failure to agree on a production cut and therefore adjusts prices downward.”
ROLLOVER OR DEEPEN?
The rise in prices following OPEC’s announcement of production cuts on Nov. 30. was consistent with this pattern.
Front-month Brent prices jumped by 23 percent from $46.38 on the day before the meeting to reach a peak about a month later of $57.10 on Jan. 6.
In the run up to next week’s OPEC meeting in Vienna, OPEC members are reportedly exploring a range of possible scenarios.
But among oil traders, the consensus seems to be that the ex ante probability of deeper production cuts is very low while the probability of a rollover is high.
No one expects OPEC would allow the current cuts to expire and flood the market with an extra 1 million barrels per day from the start of July.
If OPEC were to surprise the market by deepening production cuts, prices are likely to rise very sharply as those probabilities are reappraised ex post.
Short-dated futures contracts will likely rise more than long-dated contracts, causing the contango to narrow.
But in the event of a rollover, prices are likely to remain flat, or even come under mild downward pressure, as the residual threat of a cut is removed.
Source: Reuters (Editing by David Evans)