By Thomas H. Kee Jr.
Right now, there is a lot going right for OPEC. Here’s a quick look at how and why:
OPEC is in a position of control — competitive advantage
Producers and commercials hold big short bets
Prices may surge and overshoot to the upside
Prices may stay higher for longer
For OPEC, this is the time to act.
The market is coming to grips with something that it did not seem to be possible as recently as a few days ago: OPEC is positioned to slash production, support prices, and turn the supply-and-demand picture for crude on its head. In addition, they are positioned to do so when global investment in the space is at a very low level, and when producers are being pressured by banks to protect income streams and to not assume more risk without extreme levels of confidence.
That means producers are protecting current income streams, which is evident in the short-interest data that suggests the majority of current short-interest comes from producers and commercial sources, who typically use those as hedges to protect price points and income streams.
Producers and commercial entities hold approximately 30% more short positions than long positions according to the most recent CFTC report. On the other side of the fence, non-commercial, non-producer imbalances favor the long side, suggesting the influence of protecting income streams is acutely in play. The industry doesn't seem to trust OPEC to begin with, in fact, OPEC has purposefully taken aim at U.S. oil businesses, and every time in the recent past, OPEC has failed to make a deal.
We can all appreciate the protectionist mindset of the industry; they have been burned before when they expected a deal, but an OPEC deal certainly looks much more probable from this end at this time.
However, for protections to be unwound by these commercials and producers, they are going to need to first see a deal, and then they'll want some sense of added assurance that prices will stabilize at higher levels. If they don't need that added assurance to unwind the current hedges, they certainly will need that added assurance to invest in added production, which implies hiring.
Reasonably, added assurance will not come immediately, even if a bullish environment surfaces in the oil space for a while. Remember, there were more bullish bets on oil prices than ever before in March of this year, and WTI just tested March levels again about a week ago. Bullish bets are not themselves going to translate into an expectation of stability in the space, producers and commercials will need more. Specifically, they will need to see prices stabilize at higher levels for a while before committing new investment dollars to ramp up production. They are capable of doing this, but it won't happen immediately, and that opens the door for immediate OPEC opportunity.
Most would agree that higher prices will bring added supply online from higher-cost producers, but that will take a while, and OPEC knows it. If OPEC's hope is to get the best possible reaction from a deal, the environment right now would provide exactly that. That could even result in overshoots if the excess short positions outstanding today are unwound on the heels of a deal, and a deal looks imminent.
If OPEC reaches a deal, which we believe they will, prices can surge and hold their gains and even increase more than anyone thinks, until producers become confident that prices will stay there.
How long that will take is a question that is rather moot to us because we will probably be well out of our trade before producer and commercial confidence is restored. However, it would not be unreasonable for it to take a couple of months for domestic producers to start hiring again, and a month or two more for that production to be evident in the data. But by that time, if OPEC cuts to the degree at which they have suggested, the data will also point to a condition that as recently as a week ago seemed unheard of: Demand will be far greater than supply, and added supply may take longer to adversely impact sentiment if that type of imbalance exists.
Continue to monitor ProShares Ultra DJ-UBS Crude Oil (PSE:UCO) and Proshares Trust II (PSE:SCO) for developments.
If OPEC acts now, it may reap the rewards of higher prices for almost a year.