(Commodities, Markets)
(April 9th, 2023)
By (Andrei-Arin Pacuretu, Equity analyst)
Edited by (Ascanio Cicogna, Head of Research)
A brief introduction
The OPEC+ group, mainly led by Saudi Arabia and Russia, shocked oil markets last Sunday by announcing a surprise production cut of 1.66 million barrels per day starting in May. The most significant cuts are taken by Saudi Arabia and Russia (500,000 each), added up to a previous cut of 2 million barrels a day agreed upon back in October. These two cuts amount to around 3% of the worldwide oil supply. This article will closely analyse how this decision impacted oil prices and the stock market. Then, we will put this into the context of the general macroeconomic outlook and try to see which potential effects it may have in the future.
Context: Why did OPEC+ take this decision now?
The main reason is that OPEC+ wants to push the oil prices higher. Last month, Brent Crude briefly fell towards $70 a barrel to a one-year low, as the banking turmoil led investors to sell risky assets. Saudi Arabia state’s press service called this cut a “precautionary measure aimed at supporting the stability of the oil market”.
Another reason is Saudi Arabia’s frustration with last week’s US comments that it will take “years” to refill its Strategic Petroleum Reserve, which was partially drained in the previous year to keep stable prices after Russia invaded Ukraine. The US indicated that it wanted to stop prices from rising and would keep pressure on allies such as Saudi Arabia to maintain output. Still, at the same, it would use the Strategic Petroleum Reserve resources to put a limit on this market. In accordance, OPEC+ members felt let down and responded by cutting supplies.
Impact on oil prices
The oil prices rose sharply following this decision, close to reaching the largest-day jump since April 12th. On Monday, Brent Crude futures, the international benchmark, rose 6.3% to $84.93 per barrel, whereas West Texas Intermediate, the US marker, rose 6.1% to $80.42 a barrel. The prices remained steady throughout the week, with the Brent Crude closing a bit higher at $ 85.12, while the WTI peaked at $80.83 and closed at $80.46. (Chart 1)
Chart 1 - Source: FactSet
Impact on equities
The major US stock indexes opened mixed on the first trading session of this quarter. Despite this, all of them closed the day positively. The Dow industrials closed 2.7% higher on Monday, the S&P 500 was up 2.4%, whereas the Nasdaq Composite gained 2.2%. (Chart 2)
At the same time, shares in international oil and gas firms jumped in premarket.
The biggest gainer was ConocoPhillips, which opened 8.1% higher on Monday and closed the day up 9.2%. Exxon Mobil Corp. opened the day 4.6% higher and closed the day with a 6% gain, followed closely by Chevron Corp., which gained 4.2% on Monday’s opening and rebounded throughout the day, completing it 4.15% higher.
As a comparison, the benchmark S&P 500 index opened the trading session 0.15% higher and was up 2.3% moments after that. (Chart 3)
Chart 2 - Source: FactSet Chart 3 - Source: FactSet
How does this fit into the macroeconomic context?
The oil producers’ decision came less than a month after the banking turmoil, adding even more uncertainty to the macroeconomic outlook. The production cut will hit the oil market, which is seen as having a very tight balance between demand and supply, which could lead to a longer-term rise in prices. If higher prices last, they could push inflation up and complicate central banks’ decisions, which are caught between trying to tame rising prices and propping up a struggling banking system.
Opinions are split on whether the most recent FED rate increase was the last, but investors upped their bets slightly on one further quarter-point rise. In the most optimistic scenario, in which cuts support prices but do not push them towards $100 a barrel, the impact could be muted, given crude would remain below levels reached in 2022.
Potential forecasts
One surprising aspect was Monday’s mild reaction to the OPEC+ production cut. Here, we can distinguish two scenarios. The first is the one in which markets price in a real threat that the economy will keep running hot. In this case, the additional inflationary effects of high oil prices represent an unwelcome risk. Secondly, if markets believe the central forecast for demand is softening enough to drag down inflation, the oil price hike isn’t a real threat.
In addition to that, Société Générale’s European credit desk believes that OPEC+’s target of $90 a barrel is a huge ask. This would mean a return to levels last seen in the first few months following Russia’s invasion of Ukraine. (Chart 4)
Chart 4 - Source: SG Cross Asset Research/Credit
Potential Trade idea
According to Bloomberg’s macroeconomic SHOK <GO> model, a shock taking Brent’s price up to $100 a barrel would increase headline year-end inflation by about 80bps. Also, the 5y;5y forward inflation (T5YIFR) is highly correlated with Brent oil. With the oil prices between $60-$70, the forward inflation for five years would be around 2,2%, whereas, with prices around 100$, that would be nearly 3%. This would be another reason the Fed won’t cut the Fed funds rate target until next year. Historically, the Fed tightening cycles last around 30 months in duration.
Moreover, a study by the Federal Reserve Bank of Dallas in September 2021 suggested that if crude oil prices rose to $100 per barrel for three months before retreating, the spike would boost the annual inflation rate by 3% in the short term, with the effect fading quickly as oil prices pulled back.
Summing up, this could leave us with a potential investment based on what will follow in the oil market. In case of a shock in Brent’s price, the best trade idea seems to be a long bet on short-term interest rates, which could prove profitable, considering their historical-proved correlation.
Conclusion
To conclude, OPEC+’s announcement regarding the oil production cut brings even more uncertainty to global markets, especially following a problematic banking turmoil. For now, Brent crude and WTI prices rose sharply, as well as oil and gas equities, whereas tech stocks are down. However, there -is still a chance that this decision won’t affect central banks’ other choices that much, in case Brent’s price doesn’t move towards $100 per barrel. Finally, even with a few different possible scenarios to follow, there are still some solid opportunities for institutional investors to exploit this event in the following months.
References
https://www.wsj.com/articles/opec-members-set-to-cut-production-voluntarily-761602d1?mod=livecoverage_web
https://www.ft.com/content/1c409707-4bf6-44e5-a84c-56df95512618
https://www.wsj.com/livecoverage/stock-market-news-today-04-03-2023/card/stock-futures-mostly-slip-oil-prices-jump-after-saudi-led-producers-announce-cut-qqNAoX7xtdBdNOt21jIa
https://www.wsj.com/livecoverage/stock-market-news-today-04-03-2023/card/energy-stocks-jump-after-surprise-opec-cut-LQnnUpI7GKourUK6vqOa?mod=Searchresults_pos1&page=1
https://blinks.bloomberg.com/news/stories/RSJOIGT0AFB4
https://www.dallasfed.org/-/media/documents/research/papers/2021/wp2116.pdf
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