OPEC nears decision time: Rollover or deepen cuts?

Dhaka,  Thu,  25 May 2017
Published : 20 May 2017, 21:15:34
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Analysis

OPEC nears decision time: Rollover or deepen cuts?

LONDON, May 20 (Reuters): OPEC ministers head to Vienna next week where they are expected to ratify an extension of the current production cuts that has been agreed informally among the key participants.

Saudi Arabia and Russia announced earlier this week that they have agreed on the need to extend OPEC and non-OPEC output cuts for a further nine months until March 2018.

Riyadh and Moscow pledged the bulk of cuts under the current agreement between OPEC and non-OPEC exporters so their agreement on the need for an extension has made an extension very likely when OPEC meets formally next week.

Other OPEC ministers have already signaled support. Crucially both Iraq and Iran have stated they are in favor, which removes any remaining obstacles.

In theory, OPEC could try to surprise the market by announcing deeper cuts or an even longer extension beyond March 2018, though most analysts and traders have discounted the possibility.

Saudi Arabia and Russia left the door open by promising "to do whatever it takes to achieve the desired goal of stabilizing the market and reducing commercial oil inventories to their 5-year average".

Past experience suggests a decision to deepen the cuts would cause a sharp increase in prices in the days following the announcement but an extension would have little impact or cause prices to fall slightly.

Researchers have studied the impact on oil prices of all OPEC decisions between 1983 and 2008 ("The behavior of crude oil spot and futures prices around OPEC and SPR announcements", Demirer and Kutan, 2010).

They found that OPEC decisions to cut production caused prices to rise significantly over the following month, but decisions to rollover an existing agreement caused prices to fall slightly.

"The degree of return persistence following OPEC production cut announcements creates substantial excess returns to investors who take long positions on the day following the end of OPEC conferences," according to Demirer and Kutan.

The authors estimated excess returns on a long position to be around 7.5 per cent for the front-month futures contract and 4.5 per cent for the 12th-month contract over the course of the following month.

In the build up to most OPEC meetings, crude traders' default assumption seems to have been that OPEC would struggle to reach an agreement on cutting production and would normally take the easier course of extending existing allocations.

Decisions to cut production therefore tended to surprise the market and push prices higher, but a rollover was mostly anticipated and had little impact on prices.
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