Production cut extension likely to support, not turbocharge crude oil prices

China’s demand for crude oil is currently strong, driven by stock building and demand from refineries, some of which is reexported as fuel products. Rising oil prices into a slowing economy, not only in China, but also in Europe and later this year, potentially also the US does not in our opinion support sharply higher prices. A risk reflected in the positions held by managed money accounts, such as hedge funds and CTAs.

In addition, higher oil prices may trigger a production response from producers both in and outside of OPEC, the latter from the three producers (Iran, Libya and Venezuela) not bound by quotas and who have raised production by 0.8 million barrels per day during the past year.

Since the current uptrend began back in early July - when the unilateral production cut was announced by Saudi Arabia, WTI has rallied by 22% and Brent by 18.5%. During this time, however, the managed money position in WTI and Brent has only risen by 158.5k contracts or 158.5 million barrels to 390k contracts, well below the February peak at 491k contracts. Breaking down the increase we find the change has primarily been driven by 102.6k contracts of short covering while the gross long has only increased by 55.9k.

Do note that this group tends to anticipate, accelerate, and amplify price changes that have been set in motion by fundamentals. Being followers of momentum, this strategy often sees this group of traders buy into strength and sell into weakness. The fact that the strong momentum since July has not triggered a bigger appetite for crude oil exposure highlights the politically driven nature of the current tightness and the weakening macroeconomic backdrop.

For now, tight market conditions are still on clear display through the elevated backwardation shown across the forward price curve, not least at the very front where prompt spreads in WTI and Brent both commanding a backwardation around 65 cents per barrel, up from close to flat around the time Saudi production cuts were implemented. While the upside in our opinion remains limited there is no doubt that the current production cuts will keep the oil market tight, thereby providing support for oil prices, but whether that support translate to stable or higher prices will depend on incoming macro-economic data, and with that the outlook for demand.

From a technical perspective, Brent has been in a bullish uptrend since July and needs to hold support at $89 as a break may trigger long liquidation towards $87.5 from traders who bought the production cut extension news. In addition, the RSI is showing divergence ie the uptrend is stretched short-term. However, the medium-term uptrend is still firm with trendline support currently at $84.25, potentially being the bottom of a new higher range supported by OPEC’s active management of supply. We do not join the $100 per barrel camp but will not rule out a relative short period where Brent could trade above $90.