As OPEC’s next official meeting on 27 November draws closer, opinion is divided as to what will happen to production policy and prices. Brent prices have come down by a third since their summer highs. Money managers for the time being are reluctant to increase length; their net long futures position is less than 5% of total market open interest on the Brent contract (Chart 1). While the percentage is higher on WTI, the level of net long speculative participation in both crude futures contracts is significantly below the summer highs. While the past week has seen greater OPEC diplomacy around the oil price, and public statements by Saudi Arabia’s oil minister, Ali Al-Naimi, neither development has provided clarification as to which way the cartel is heading. All that is certain is that the outcome is binary. Either we see a reduction of significance in OPEC output, commensurate with the decline in the call on OPEC crude in Q1’15, or we do not witness any cuts, or at least none of any consequence.
Viewpoints: the case for and against cuts
The view that OPEC will not cut its supply and so allow the oil price to decline and eventually crowd out the higher-cost marginal producer (US shale oil) assumes OPEC has forfeited its role and has lost control of the price. In essence, even if it were to cut its production, this would not have any impact on price because of highly scalable US production. However, global oil supply is not perfectly elastic as a result of US shale production growth due to market imperfections; the US still places severe restrictions on the export of its crude oil, and it is not currently in a position to displace all its foreign imports of crude oil with domestic production. We stand on the other side of the argument, namely that to try to crowd out US oil supply in 2015 is futile as lower price levels would be required for a prolonged period of time1, suggesting that the opportunity cost of this course of action would be too great. Rather, Saudi Arabia is playing a ‘game of chicken’ to incentivise collective action and avoid a free rider problem.
Trading the OPEC meeting
To date, various OPEC headlines do not support decisively one side of the argument over the other. It is particularly interesting that OPEC’s decision will come on Thanksgiving, when US markets are closed and liquidity low. Price action may prove highly volatile. Looking at skew (Chart 2), the 1 Oil Market Comment (13/11/14) OPEC: deafening silence market is pricing downside risk more expensively than upside risk, suggesting negative sentiment – the oil price may move further down in the case of no OPEC action than rise in the case of an OPEC cut. In any case, prices will not stay at current levels. As such, a long straddle position for Mar’15, expiring sufficiently after the OPEC meeting, may be an opportunity to trade the binary outcome. Going long straddles is always preferable ahead of announcements, notably if prices were to consolidate before the announcement. But the long position always needs to be viewed against time decay – as such Jan’15 may be too close. Admittedly, one strongly limiting factor is implied volatility (Chart 3), which has picked up with the fall in prices, making owning straddles an expensive proposition.
