Respect, But Don’t Buy Production Cut Rumors

Respect, but don’t buy production cut rumors. Add to shorts

Respect, but don’t buy these production cut rumors. In short, nothing has changed on the macro supply/demand front. If anything, the supply glut has worsened this week with Iran, Saudi, and Abu Dhabi having confirmed production increases. Furthermore, the only countries that are actually lobbying for production cuts are the ones who actually can’t afford to implement cuts, a la Venezuela, Angola, and to a certain degree, Russia. Three major hurdles exist to implementing production cuts:

1. Saudi needs to be willing to take a lot of egg on their face.
Caving would: (a) reduce the Kingdom’s strength as leader of the cartel, (b) paint the Saudi leadership’s willingness to part with billions in lost reserves and its incursion of foreign debt as weak and foolish, and (c) undermine the entirety of Saudi’s long-term strategy. Saudi would not have embarked on this course if they weren’t expecting these price levels and willing to take the pain and ride out the storm.

2. The cartel needs to actually implement cuts.
I can’t for the life of me see compliance from Venezuela and certainly not from Iran. After being forced to sit in timeout for the last four years – during which oil prices were significantly higher, you can be assured the Supreme Leader is likely to be rather rebellious, especially towards the best interests of the Saudis.

3. Debt service needs to become more problematic for US marginal producers.
We haven’t seen enough bankruptcies nor pain to put a dent in the US as a swing producer. Production cuts will extend financing credit for another quarter for these marginal producers, who in many cases will increase production on a sustained move above $40.

That said, with shorts at all time highs and net positioning becoming more short, traders can’t take the risk of any cut rumors actually being true. Therefore, you are wise to expect and respect large bullish moves on short-covering. We’ve seen the last two massive API builds as short-covering signals. Last week’s build marked a local low and ushered in an 18% rally. This week’s historic API build also marked a short-covering low from which we’ve also since seen a 19% rally.

The BOJ’s overnight move is bullish for risk assets in the immediate term and we should expect to see oil trade higher with global equities. However, the reason the central bank acted further underscores the threat of a global slowdown. I expect shorts to build as this grim reality displaces bullish exuberance and it becomes clear production cuts aren’t in the cards.

36 is an obvious resistance level. I’d watch for a failed attempt above 35 to add to shorts with a target of 31.35 at the prior consolidation support zone.

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