Why Oil Production Cut Talks Between Iran, OPEC Are Just Noise

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OPEC

Saudi Arabia and Iran are at it again, discussing oil production cuts in order to generate some market headlines. It’s working insofar as generating speculation, but in the end most of it is meaningless.

Even if Saudi Arabia and Iran were to agree on a production cut, who would enforce it? These two countries’ governments do not like each other and there is no reason that they would respect any agreement on a production cut even if a deal was signed. Breaking such an agreement while publicly keeping up the pretense of enforcing it would be especially profitable for the cheating party. They’d be able to sell more at higher prices than the other, which means that the incentive to cheat on a deal and suspect the other of cheating is high. This is why bona fide voluntary cartels for the purpose of maximizing revenue by cutting output are practically impossible.

Practically, this is the same for the whole OPEC cartel, except that most of OPEC has submitted to the de facto rule of Saudi Arabia as the biggest exporter in OPEC. OPEC operates primarily through fear of its most powerful member cutting off markets to the relatively weaker OPEC members. It is fear that keeps the cartel together, enabled by Saudi Arabia’s leverage of the other countries in the group. Any potential or actual deal between Iran and Saudi Arabia would not have the same fear factor because one does not clearly dominate over the other.

Any agreement would have to actually be an agreement that could be enforced on a practical level, though it would have to be on the honor system because there is no way to ensure that either country would actually be following it.

But that doesn’t mean that these talks and balks and fits and starts do not have value for oil traders. They do, because they help expose the actual sentiments on the ground revolving around the oil price. If, for example, a deal were announced to cut production between these two countries, signed and sealed, we would expect oil markets to rally. If the oil markets were not to really or at least rally very modestly, it would be a sign that the oil market is ready for a rebound.

On the other hand, if an expected deal were to fall apart and the oil price only dove modestly or did not decline at all, we would take from there that the decline is over.

The news is important in a way in terms of exposing the thoughts and intention of market makers and comex traders. They also have the potential of signaling mid-term trend changes, not necessarily because they are actually important in terms of their effects on the supply and demand picture, but just because of the fact that people tend to hold off their investment activities until one of these big news stories actually happens.

The volume of everyone suddenly trading at once, similar to the market in general following an FOMC meeting on rate hikes, can serve to change a trend, and can be an important turning point in a commodity market, but not because of any particular decision made during the meeting.

Regardless of any resolutions, markets will remain as before, perhaps with a few days of unusual activity. But if you are either an oil bull or an oil bear, it may be safer to place initial trades on these big market days focusing on foreign partnerships and inventory numbers as well.

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