OPEC Production Cuts: Oil Market Listens, For Now

(Bloomberg Gadfly) -- Earlier this year, Saudi Arabia's Minister of Energy and Industry echoed Alan Greenspan in warning against "irrational exuberance" that his country, or OPEC, would support oil prices simply so rivals could get a free ride. In the weeks since, Khalid Al-Falih has swapped out Greenspan for another central banker: the European Central Bank's Mario "whatever it takes" Draghi.

Just over a week ago, Al-Falih used that very phrase to emphasize OPEC's commitment to draining the glut of oil inventories weighing on prices. And just this weekend, he apparently put substance behind the rhetoric: He said Saudi Arabia and Russia -- which together produce more than a fifth of the world's oil -- favor prolonging through the first quarter of 2018 supply cuts they and other countries announced last November. As it stands, OPEC is due to meet on May 25 to decide whether to extend the cuts to the end of the year. Oil prices duly jumped.

"Jumped" maybe the wrong metaphor in this case, though; "stepped back from the brink" could be more apt:

The net long position of managed money in WTI and Brent crude oil futures shows the arc of belief in OPEC's power from November to now. Like any good central banker, or aspiring one, Al-Falih's verbal intervention was designed to revive flagging confidence in the power of his office.

Without it, prices might well have turned south again. The same weekend, it was reported that oil production in Libya, exempt from production cuts due to its civil strife, hit its highest level since October 2014, before the crash really hit its stride. This came after a report on Friday that Indian oil demand -- a critical element of the bull case for prices -- had risen in April after three months of declines, but was still lagging far behind the gains witnessed in 2016.

Saudi Arabia's ultimate aim, along with that of fellow producers, is to shift the futures curve for oil to a point where it no longer makes sense for traders to put oil into storage and sell it for a higher price down the line. Undermining this carry trade means reducing the discount at which physical oil trades relative to longer-dated futures. You can see that this has moved somewhat in OPEC's favor over the past week, helped by a drop in U.S. oil inventories reported last Wednesday and, of course, this weekend's well-chosen words:

With 10 days to go until OPEC's meeting, a combination of well-chosen words and the short positions built up by hedge funds suggest prices could go higher.

Yet it would be a mistake to conclude the tide has shifted in favor of Saudi Arabia, Russia and the rest.

That curve has flattened out before, almost flipping in February, only to dip again when it becomes clear there is no quick fix to what ails oil exporting nations. Higher prices, regardless of their foundation, encourage the rebound in U.S. shale development, which counteracts the supply cuts.

Above all, once the speculative heat around the May meeting dissipates, the reality of the situation should re-emerge, with Al-Falih's own odyssey providing the essential narrative. In January, he speculated the initial cuts probably wouldn't need to be extended beyond June. By March, he was sounding that warning about irrational exuberance. Come early May, he let it slip the cuts might extend into a vaguely defined "beyond." And now, not long after, the cuts look set to push into 2018.

For those encouraged by the minister's adoption of the Draghi doctrine, it is worth remembering the ECB chief took that stance as a desperate measure -- and that, five years on, he is still playing backstop and choosing his words very carefully.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

To contact the author of this story: Liam Denning in New York at ldenning1@bloomberg.net.

To contact the editor responsible for this story: Mark Gongloff at mgongloff1@bloomberg.net.