Surprise, squeezing the shorts, and revealed preferences

Some thoughts on the voluntary production cuts announced by OPEC⁺  on April 2

John Kemp

3 April 2023

Saudi Arabia and its allies in the OPEC⁺ group of producers surprised the oil market by announcing “voluntary” production cuts totalling more than 1 million b/d on April 2.

The surprise stemmed from the unscheduled timing of the announcement; the scale of the cuts; and the fact officials had repeatedly briefed no production adjustments were needed until just a few days earlier:

• The announcement came a day ahead of the already scheduled meeting of the Joint Ministerial Monitoring Committee tasked with reviewing market conditions and production policy on April 3, with producers’ in effect front-running their own meeting.
• The announcement was made when markets were closed on a Sunday, ensuring it would generate a strong price reaction when they re-opened on Monday – especially during thin trading and liquidity in Asia before European and North American markets opened.
• Cuts of almost 1.16 million b/d, in addition to already announced cuts by Russia of 0.5 million b/d, were at the higher-end of the scale of recent adjustments and suggest a fundamental alteration in strategy rather than a minor tactical change.
• Until three days before the announcement, OPEC⁺ officials had been briefing journalists there was no need to change and current output levels were likely to be maintained until the end of 2023.
• Five delegates of the producer group told Reuters on March 30 that OPEC⁺ was likely to stick to its existing deal to cut oil output at a meeting on Monday.
• Saudi Arabia’s oil minister said in an interview with Energy Intelligence as recently as March 14 that OPEC⁺ would stick to production levels until the end of the year.
• Being very precise, the Saudi oil minister said: “There are those who continue to think we would adjust the agreement … I say they need to wait until Friday December 29, 2023, to demonstrate to them our commitment to the current agreement.”
• In the last two week, there have been no significant changes in oil market fundamentals that could explain the significant change in position.
• Prior to the announcement, front-month futures for Brent and U.S. light crude had been trending higher after hitting a 15-month lows on March 15.
• Front-month Brent prices were trading in the 41st-46th percentile since 2000 and 2010 respectively, after adjusting for inflation, so they were not especially low.

The logical inference is the announcement was deliberately planned to surprise the market and generate a significant increase in prices.

SQUEEZING THE SHORTS

Saudi Arabia and its allies appear to have employed the element of surprise to accelerate and amplify a short-covering rally already been underway for around 10 days.

By March 21, hedge fund and other money manager positions in crude (Brent + WTI) had fallen to 226 million barrels, very close to the record low of 215 million barrels since 2013.

Bullish long positions outnumbered bearish shorts by a ratio of 2.11:1, in only the 8th percentile for all weeks since 2013.

Bearishness was especially evident in WTI, where funds had amassed short positions amounting to 127 million barrels on March 21, up from 56 million on March 7.

Large concentrations of short or long positions usually precede an abrupt turning point in the recent trend as liquidity declines and fund managers attempt to realise profits.

Funds had already started to reduce their short positions over the next seven days to March 28, purchasing a total of 40 million barrels, mostly to close out shorts.

Buying was heavily focused on WTI, where 49 million barrels were purchased in seven days, the fastest buying since the first wave of the epidemic in April 2020.

The best time for policymakers to influence a market is not when it is trending strongly but when it has recently turned, and the emerging trend can be turbocharged.

The voluntary cuts announced by OPEC⁺ are likely to accelerate and amplify the short-covering rally, which seems to have been the purpose of the carefully executed surprise.

ACTIONS NOT WORDS

Given the abrupt shift in policy, how much reliance should traders place upon briefings and other forward-guidance from officials about future changes to output targets? 

For some years, I have largely discounted briefings and forward-guidance and chosen to focus only on the actual decisions themselves (actions not words).

Briefings may be unreliable for several reasons:

• Policymakers may not know themselves what they will do in future any more than traders and investors, because they cannot predict the circumstances they will face.
• Policy tends to be reactive; officials cannot bind themselves to a strategy that may turn out not to be optimal as circumstances change.
• Forward policy commitments often suffer from a time-inconsistency problem: if officials can successfully convince traders they will pursue one course of action, there may be advantages in surprising them by adopting another.

OPEC briefings, like forward guidance from central banks, are an unreliable guide to future policy actions, and the useful information content is often low.

Focusing on what policymakers actually do, rather than what they say, is a more fruitful approach.

OPEC⁺ MARKET POWER

For the same reasons, it is more useful to focus on what decisions empirically reveal about policymakers’ preferences and goals, rather than rely too much on what they say about their motives.

Like central bankers, oil market policymakers are not usually totally transparent about why they do things – they may not even fully understand themselves.

In briefing the media or traders, policymakers are not on oath to tell “the truth, the whole truth, and nothing but the truth”.

Rather than worrying about motives, which cannot be reliably observed, it is more helpful to focus on what economists call revealed preferences, which can be inferred from visible actions.

The production cuts announced by OPEC⁺ have revealed a preference for higher prices  in the upper half of the long-term real distribution.

They have also revealed a preference to try to maintain prices at a higher real level throughout the cycle.

OPEC⁺ has revealed a preference to move the entire distribution of prices higher and achieve a higher through-cycle average.

OPEC⁺ can exercise this market power at the moment because of the lack of a production response from U.S. shale firms and other non-OPEC non-shale (NONS) sources of supply.

U.S. shale and NONS supplies increased only modestly in 2022 despite very high prices following Russia’s invasion of Ukraine.

U.S. shale production growth is already flattening following the retreat in prices since the third quarter of 2022.

In this context, OPEC⁺ can exercise significant market power by restricting its own production to achieve higher prices.

The main constraints are (a) the risk of a recession and (b) the emergence of new sources of supply from outside OPEC⁺ and the U.S. shale plays.

Recession remains a risk in the short and medium term, but new sources of supply threatening OPEC⁺’s market power are only likely to materialise in the longer-term.