As Brent crude threatened to move below $70 a barrel, stories of potential OPEC oil production cuts seemed to surface. Saudi Arabia over the weekend suggested that it intend to reduce supply by 500,000 barrels per day in December as it fears the building of inventories amid uncertain demand prospects.
Saudi energy minister Khalid Al-Falih told reporters that Saudi Aramco's crude nominations would fall by this amount on back of lower seasonal demand, but then they had increased production by 1 million barrels per day, so it was only coming off of a higher base. The group is contemplating cutting up to 1 million barrels per day as it is worried prices could fall much more.
This would be a rather premature move, especially given that we do not fully know the impact of Iranian sanctions yet. It was only about a month ago the world was talking about "low spare capacity," where the idea of cuts would seem preposterous. How things change in four weeks' time as prices fall.
From the highs in October where Brent traded at $85 a barrel, hedge funds have sold the equivalent of a half-billion barrels of crude oil and refined products in the last six weeks. This is the largest reduction in any six-week period since at least 2013. Funds are now 4:1 long vs. short positions compared to more than 12 to 1 at the end of September.
The oil market moves with a bit of a time lag. The worries on the demand side surfaced over the summer as emerging market economies were collapsing, but the timing was not easy to play the short side as we were in the midst of the key summer driving season, where gasoline demand is higher. Those demand fears are playing out now.
Looking at the performance of all asset classes and commodities over the past three months, it is no surprise that oil finally has normalized with the current economic cycle. But the supply side has come back with a vengeance, as it does when prices rally; it just takes time for it to actually come to the market. Judging by the rig counts seen earlier this year, the production is being seen now as U.S. shale producers have increased output by more than 2 million barrels per day in the 12 months to August. It's a case of Sod's law, at a time when we are in the weak seasonal period before fourth-quarter demand kicks in.
The market is also pondering the existence of having an OPEC to begin with. We know that OPEC is really just Saudi Arabia and Russia steering the committee with production cutbacks and increases as they see fit, with a focus to keeping prices healthy for the global economy and themselves. After all, they do not want to kill the goose that is laying golden eggs for them. It would have severe ramifications for the oil market, not to mention petrodollars and the dominance of the dollar going back to the Bretton Woods system engineered in the 1970s.
Whether or not this institution is dissolved altogether (I believe chances are very remote), the fact remains that oil production and physical fundamentals will not change. There is too much at stake for the region to do away with the petrodollar for now, especially when China is coming up head to head trying to push the "petroyuan" forward along its One Belt One Road initiative and its plans for Eurasia trade.
The oil market is no man's land; it will continue to be a source of shorts for now. It is not cheap yet. There are a lot of asset classes and stocks trading at 40% discount to their net asset value; why try to chase the oil price today? To see true support, we need to see how winter heating oil demand kicks off. But inventories are a lot more comfortable now than they were last year.
If there is a broader China/global stimulus-driven rally, commodities such as copper, iron ore, steel and their respective equities will rally more than oil as the discounts are more apparent. For that to happen, we need some resolution going into the G-20 Summit or some agreement between China and the U.S. Until then, base metal commodities will trade in a tight range with their fate attached to the yuan and U.S. dollar.
