Saudi Arabia Juices the Oil Price

By John Banks

A little over a month ago, on Dec. 8, 2020, TradeSmith Decoder went long a sizable basket of oil and gas stocks in the model portfolio.

Price action was flashing a green light — always a requirement for new positions — and our bullishness was rooted in the beaten-down profile of energy stock valuations; the demand-boosting prospects of a vaccine-powered recovery; the outlook for a weakening U.S. dollar (which could help lift the oil price); and the rising prospect of inflation in the coming year. 

And then, last week, Saudi Arabia gave us a gift.

Seemingly out of nowhere, in the aftermath of the Jan. 5 OPEC-Plus meeting, the Saudis announced a unilateral, million-barrel-a-day production cut, set to last for at least two months.

The response to the cut was electrifying. The West Texas Intermediate crude oil price, which had already responded bullishly to the official meeting, jumped more than 5%, to close at a 10-month high, after the Saudis revealed the surprise news.

The surge sent the oil price above $50 per barrel for the first time since the dark days of the pandemic and sent a variety of oil and gas stocks rocketing higher. Multiple names in our basket were up 5% to 10%.

“We gave the oil industry a wonderful present and a wonderful surprise,” said Saudi Energy Minister Prince Abdulaziz bin Salman.

The price cut was the brainchild of Crown Prince Mohammed bin Salman, the half-brother of the Energy Minister, and de facto ruler of the Saudi Kingdom, who goes by the initials MBS.

Energy analysts considered the move to be classic MBS: Bold and brash with a taste for drama, though not necessarily thought through in the longer term.

Saudi Arabia, as the leader of OPEC, is playing a complicated game with at least four opponents in mind: Russia; oil-trading hedge funds; the U.S. shale industry; and the novel coronavirus.

OPEC-Plus is composed of OPEC, led by Saudi Arabia, and an additional producer group led by Russia (hence the “Plus”), with 23 members total in the expanded group.

Saudi Arabia and Russia have a “frenemy” (friend yet enemy) type relationship. They do not like each other much, but they fear and despise the U.S. shale industry even more.

After getting into a short-lived price war last year, Saudi Arabia and Russia mended fences in response to the dire threat posed by the pandemic. With global oil demand hammered by the pandemic (nobody traveling anywhere), OPEC-Plus cut oil production by 9.7 million barrels per day, with plans to add it back slowly as the global economy healed.

By end-of-year 2020, Saudi Arabia and Russia were again at odds. The Saudis were inclined to keep production reined in, just in case new lockdowns were imposed and the pandemic grew worse with the vaccine rollout going slower than expected.

Russia, on the other hand, was more worried about competition from the U.S. shale industry and preferred to accelerate a return to full output while betting on recovery.

The result, as revealed at the Jan. 5 OPEC-Plus meeting, was something of a bullish compromise for the oil outlook. The group had agreed to keep oil output flat, rather than raise it by 500,000 barrels per day as Russia preferred.

And then, after the official meeting, Saudi Arabia sprang a bullish trap for the hedge funds that had been shorting long-dated oil contracts. The Saudis announced that, unilaterally and of their own accord, they would be cutting the million extra barrels.

Russia and Kazakhstan were allowed a tiny increase of 75,000 barrels per day each, likely as a form of concession to the Russians. The Saudis suggested they would cut an additional amount to offset the Russia and Kazakhstan amounts, too.

The Saudi Energy Minister stressed the decision was made by MBS himself. “We are the guardian of this industry,” he added.

The Saudi production cut can be seen as a combination insurance play, short squeeze, and shale gamble, all rolled into one. The net result is that it’s a big positive for U.S. energy stocks.

The production cut was an insurance play because Saudi Arabia, and most of the producers in the traditional OPEC group, are still worried about demand risks created by the pandemic. If new lockdowns are imposed, or if the vaccine-powered recovery is delayed by the slowness of getting shots into arms, the Saudi cut will provide something of a buffer against that.

The production cut was also a deliberate bit of gamesmanship, meant to short squeeze oil-bearish hedge fund managers who were caught leaning the wrong way. MBS kept his plans quiet to deliberately catch these players unaware.

There is a popular, long-dated, WTI oil-futures spread that energy-focused hedge funds like to trade, known as “Dec-Red-Dec” because it juxtaposes the December oil futures contract and the December contract of the following year. (“Red” refers to a contract that is an additional year out.)

When the cut was announced, the spread jumped to a 12-month high, forcing a painful round of short covering, which further boosted long-dated oil prices.

Then, too, the Saudi production cut was a gamble because the risk exists of U.S. shale producers filling in the gap. Were U.S. shale producers to ramp up production immediately in response to the higher oil price, both Saudi Arabia and Russia could lose market share as the profits from a higher price go to a despised competitor.

The shale gamble looks like it will pay off, though, because U.S. oil and gas producers seem more focused on paying down debt and solidifying dividends than trying to immediately ramp up production with oil prices back above $50 per barrel.

If Saudi Arabia has played its cards right, and the vaccine-powered recovery continues to unfold, the oil price could continue to march higher over the course of 2021 as resurgent demand couples with an ongoing fall in the U.S. dollar.

The ideal combination, and the thing the Saudis are hoping for, is to see a renewed wave of optimism kick in just as their multi-month cuts expire, helping lift the oil price back into the $60 to $70 range. That combo would, in turn, be very bullish for energy stocks.