Have Oil Traders Misread Saudi Arabia's Production Cut Commitment?

I have said it many times before in these pages and will no doubt say it many times in the future too, but it is often the case that a traded instrument moves based more on market mood and sentiment than on any hard facts. For traders, "facts" are open to interpretation, and how they are interpreted decides what impact they have on price. However, moods change, and there are reasons to believe that the pessimism around crude that traders are currently exhibiting may be about to shift.

Last weekend, the Saudi government reiterated its commitment to voluntary crude output cuts of 1 million barrels a day, saying that they would continue until at least the end of the year. That is a fact that, on the surface, would seem to be very bullish for oil. Tight supply was the theme in the market from June to September as crude climbed by over thirty percent, so a confirmation of tight supply going forward should be bullish, right?

You would think so…but that announcement came over the weekend, and the 1-week chart for the front-end WTI contract (CL) looks like this…

So, what has changed? Why is what should be bullish news prompting selling?

It is all to do with that malleability of "facts" that I mentioned above. The fact is that the Saudis are continuing with reduced production. But, in the current environment, that is being interpreted as sending a bearish message. "Why would they do that?" is the question being asked, and the most popular answer is because they are worried about a global recession and a big drop in demand for oil as a result.

It is possible the Saudis are thinking that way, but they first cut output in July. Back then, with a different mood in the market, the million barrel/day reduction in crude supply was seen as what it theoretically should be, supportive of oil prices. Very few people thought that the Saudis were cutting their output because they were worried about the future. They didn't overthink things; they just assumed that the Saudis were trying to force prices higher. The new interpretation, that it is a product of fear, falls afoul of Occam's razor, a philosophical and mathematical construct that states that the most obvious answer is almost always correct. It is, in effect, a fancy way of saying "If it looks like a duck…", and the commitment to maintaining lowered output levels looks, walks, and quacks like an attempt to put upward pressure on prices.

The Saudis and their OPEC+ partners have obvious reasons for wanting to see oil prices higher. They have a lot of it, for one thing, and they know that higher oil and therefore gasoline prices can cause economic pain and political instability in America. I don't want to sound like some paranoid American nationalist, but neither Russia nor Saudi Arabia, nor quite a few other OPEC+ members, see those things as undesirable. So, it is far more likely that this is about trying to force prices higher than it is about a secret, much gloomier growth outlook from OPEC, the Saudi government, or whoever else. 

None of this means that oil prices will bounce back immediately. We may have to go a bit lower, maybe to around $70 before the market turns because as long as the market wants to interpret everything as bearish, any news will prompt selling. However, at some point before too long, the reality of tight supply in the physical market has to have an impact. When it does, the current popularity of short positions could cause a rush to the exit that speeds up and exaggerates the bounce, so trading with a long bias for a while is probably advisable and if we do get to around $70, I will be buying crude futures and/or some oil stocks in anticipation of a reversal.