Markets skeptical of a lasting oil production cut
Russia has nominally committed to cutting its oil production by 300,000 barrels over the first few months of 2016. How did oil and financial markets react? How will they react in the near future?

Oil prices have risen by around 20 percent since OPEC declared a deal, reaching $55/barrel, suggesting that markets find the proposals to be credible. However, these gains mask latent concerns that the deal will fall apart shortly after its launch.

Recall that unlike stocks, oil is a physical commodity, and spot trade accounts for a very small percentage of trade. Most exchange occurs using term contracts and futures markets, and both buyers and sellers have the opportunity to build up significant inventories—which they have been doing lately, at record levels.

Accordingly, headline oil prices are less informative about market fundamentals than typical financial securities. If the OPEC and non-OPEC pact to decrease output holds firm, we can expect oil prices to increase beyond $60/barrel, as the prevailing oversupply will be eliminated. However, there are historically high levels of uncertainty over the buoyancy of oil prices, because nobody really knows how U.S. shale oil producers will respond to rising prices.

The uncertainty extends to the producers themselves, who are still exploring and adapting their productive technologies in response to highly competitive conditions.

However, the more likely scenario is an unraveling of the accord, as producers violate quotas. OPEC’s track record in this regard is dismal, with a 4 percent quota compliance rate during the period from 1980 to 2009.

Moreover, the last time they tried to cooperate with non-members, Russia committed to cutting its output and ended up increasing it instead.

The reason for such poor compliance is that OPEC suffers from poor monitoring, and zero accountability. Algeria, Kuwait, and Venezuela have been tasked with ensuring that nobody exceeds their quota, but it is unclear how they will do that.

What sort of manpower is needed to monitor the numerous production facilities that are currently operational? Furthermore, in the event that a violation is uncovered, there are two retaliatory options: writing a strongly worded letter admonishing the violator, or cheating on your own quota. If neither sounds convincing, then you agree with most oil traders.

Looking beyond oil markets, the emergence of U.S. shale oil has fundamentally altered the relationship between oil, the U.S. dollar, and U.S. government bonds.

In the 1970s, during the era of oil shocks, oil imports were critical to the health of the U.S. economy. Additionally, the Bretton Woods system of fixed exchange rates and guaranteed gold-dollar convertibility was placing great stress on the U.S. dollar.

Under this configuration, rising oil prices would hurt the U.S. economy, causing the greenback to tumble, and sending bond yields up.

The 2016 U.S. economy looks very different. The shale oil revolution means that the economy’s dependence upon oil imports has diminished significantly.

Further, with Donald Trump’s victory in the presidential election, the Keystone Pipeline is likely to be completed, further altering the United States’ interaction with global oil markets. In fact, the U.S. now exports oil, after the ban was lifted last year, and so significant components of the economy now benefit from rising oil prices.

The weak state of global economic growth, especially in the European Union and Japan, means that the U.S. is more attractive than ever. In fact, the Federal Open Markets Committee demonstrated its satisfaction with the state of the economy Wednesday when it raised its target federal funds rate 0.25 percent, rather than continue an expansionary monetary policy.

To see the change in the U.S. economy’s relationship with oil more clearly, note that in the 1970-2000 period, U.S. bond yields tracked oil prices, rising together from 1970-1980 and then falling together until 2000.

In the period after 2000, which is when shale oil entered the fray, real oil prices ballooned until 2014, and subsequently retreated heavily, whereas bond yields fell more or less continuously, reflecting a much weaker relationship between the two.

Therefore, oil markets now have a modest effect on the U.S. economy, the dollar, and on government bonds. The dollar will remain strong, and U.S. bond yields will remain low as long as the U.S. economy continues to thrive, and the EU and Japan continue to struggle.

However, more important is the fact that markets are not really buying into the hype regarding OPEC’s resurrection, and so there is nothing really for the U.S. dollar or U.S. bonds to react to. On this occasion, the Russian bear’s growl seems much louder than its bite.

August 2017
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