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* Chart 1: tmsnrt.rs/2gwFSXn
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* Chart 5: tmsnrt.rs/2hp0eSe
By John Kemp
LONDON, Dec 13 Saudi Arabia has transformed
sentiment in the oil market by assembling an unprecedented
coalition of oil producing countries to agree output cuts in
Saudi officials have obtained pledges from OPEC members to
cut production by almost 1.2 million barrels per day and from
non-OPEC members by an extra 560,000 bpd during the first half
In the process, Saudi negotiators wrong-footed many hedge
fund managers, who had established large short positions in
futures and options last month expecting there would be no deal
or only a very weak one.
Hedge fund managers increased their short positions in the
three main crude futures and options contracts by more than 200
million barrels between Oct. 18 and Nov. 22 amid scepticism
about any deal.
But as negotiators narrowed their differences and then
announced a deal among OPEC members nearly all those positions
were closed: shorts were reduced by 174 million barrels in just
two weeks between Nov. 22 and Dec. 6.
Saudi Arabia thus executed a successful short squeeze
(whether that was the intention or not) and forced crude prices
higher as bearish fund managers were forced to buy back their
loss-making short positions.
Hedge funds in turn fuelled the rally by opening an extra
154 million barrels of crude long positions over the last four
weeks, including 94 million barrels opened the week after the
OPEC deal was announced.
The hedge fund community has therefore pivoted from a
relatively bearish position on Nov. 15 (when funds held a net
long position of just 422 million barrels) to a bullish one on
Dec. 6 (with a record net long position of 895 million barrels).
Brent prices have been jolted up from less than $45 per
barrel in mid-November to over $55 in recent trading.
And Brent time spreads, seen as an indication of the
expected supply-demand balance, have strengthened, though most
of the tightening has come after the first half of 2017.
The abrupt shift in sentiment has led many analysts to
conclude OPEC has returned to its former role as an active
market manager after a number of years as a passive onlooker.
OPEC's return may be overstated. As in the past, the key
role has been played by Saudi Arabia, in conjunction with its
close allies, with Riyadh persuading other producers to lend
Nonetheless, Saudi Arabia has succeeded in banishing the
bearishness that haunted the oil market over the last six months
and converting most hedge fund managers into oil bulls.
The resulting increase in prices will make all OPEC and
non-OPEC producers better off and helps vindicate the deal.
Oil exporters are less likely to cheat if the deal delivers
the promised significant improvement in revenues, at least at
All the components for a successful deal to restrict oil
output, cut excessive stockpiles, and drive crude prices higher
have fallen into place.
Market conditions and price movements resemble those during
previous successful deals in 1999/2000 and 2008/09.
The International Energy Agency assesses the OPEC and
non-OPEC agreements could move the crude market into a deficit
of 0.6 million bpd during the first half of 2017, if they are
Full compliance is unlikely. Energy professionals expect
OPEC countries to achieve only around half of the promised cuts.
But the assessment gives some indication of how much
non-compliance could be tolerated before the deal unravels.
The challenge for the Saudis now is to keep the hedge fund
managers on side to avert a sell off that could push prices
Many funds appear to follow momentum-based strategies
(buying when prices are rising and selling when they are
So the very large concentration of hedge fund long positions
has created significant downside price risk if prices stop
rising and start to pull back.
To keep the funds bullish, the Saudis need to turn the OPEC
and non-OPEC agreements into a evidence of a real reduction in
crude supplies and a drawdown in stocks.
Saudi Arabia and a number of other exporting countries have
already begun to notify refiners shipments will be cut in
January, with news leaked to the media.
Since stockpiles are most transparent and reported with the
highest frequency in the United States, it would make sense to
engineer a reduction in shipments to the United States and try
to cut stocks on U.S. territory.
Nothing succeeds like success. Saudi Arabia needs clear
evidence the deal is working to keep the hedge funds long and
prices high, which in turn will encourage compliance with the
deal, at least in the early stages.
The biggest risks come from non-compliance by OPEC members
or Russia; a sharp rise in shale output; rising production from
uncapped producers Libya and Nigeria; a drop in oil demand; or a
fall in crude prices themselves.
If oil prices start falling, many hedge funds with long
positions may be tempted to reduce them and take some profits.
The risks from all these sources are considerable and are
likely to increase over time; any one of them could cause the
OPEC and non-OPEC agreement to unravel if the gains from
cooperation start to fade.
For now, however, Saudi Arabia has intervened successfully
to shift sentiment and been rewarded with a price improvement of
more than 20 percent.
(Editing by David Evans)