The Organization of the Petroleum Exporting Countries (OPEC) last week decided upon the highly anticipated production cuts. However, in reaction to the news the crude oil prices dropped again, as a classic case of buy the rumor sell the news. The goal of the oil cartel with these cuts was to keep the floor on crude oil prices above $50/bbl but it looks it has failed yet again.
Previously, this column has highlighted the ineffectiveness of OPEC. The cartel has barely any control over the production of its members. During meetings most members agree on the cuts but in reality they do not adhere to it and in some cases more pumping has been witnessed.
This nuisance of lower oil price for the oil producing countries has brought together two strange bedfellows which are Russia and Saudi Arabia both of which are leading the production cuts. The market, however, wants further cuts because of increasing global oil inventories especially in China and significant drop in breakeven price of shale oil.
The main cause of concern for OPEC is the shale producers who have been very smart about their business. The shale boys have over the years improved their technology and discarded expensive rigs. On the other hand, most have hedged themselves in the futures market against the drop in oil prices. Market analysts are of the view that most shale operators are hedged below 60 dollars. Moreover, shale operators also have the freedom to sell at any rate they seem feasible. Even a dollar profit per barrel keeps them afloat. On the contrary, the Saudis and the Russians have a country to run which is largely depending on energy prices.
Secondly, China which is the biggest consumer of oil is slowing down economically. It is storing oil just for security purposes and would soon have enough. Apart from China no other country has enough appetite create a demand supply gap in the oil market.
Another aspect to the crude prices are the net speculative long positions undertaken by hedge funds mostly. These speculative positions were at extraordinary levels around March which in itself was a red signal for the oil because the prices were moving sideways and the speculators were exposed to any negative event. One of the reasons for oil prices plunging post-OPEC meeting can be the covering speculative positions.
Going forward, oil prices might have some respite as summer and driving (travel) seasons across the developed world starts but post August if there is no significant change in global inventories and the shale production maintains its current pace, the prices can drop further and retest $40/bbl level again.
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