Oil traders seem increasingly convinced OPEC’s prompt action in cutting production will be enough to offset the impact of rising shale production and slowing global growth.

Brent futures prices have stabilised around $60 per barrel in recent sessions, well below the peak of over $85 at the start of October, but significantly higher than the trough of less than $50 in late December.

More importantly, Brent’s six-month calendar spread has strengthened from a contango (discount) of almost $1.80 per barrel to just 35 cents over the same period.

Calendar spreads have been correlated with the changing balance between production and consumption, alternating between contango and backwardation as the market cycles between over- and under-supply.

The narrowing discount on futures for early delivery in recent weeks indicates traders expect the market to be less oversupplied than before.

Stronger spreads suggest OPEC’s cuts have succeeded in shifting market expectations about the outlook for 2019.

PROMPT REDUCTION

Saudi Arabia and its OPEC and non-OPEC allies have implemented substantial reductions in production and exports during December and the first part of January.

OPEC crude production declined by 750,000 barrels per day in December, according to industry sources surveyed by the OPEC secretariat.

Most of the reduction came from Saudi Arabia (470,000 bpd), but there were also substantial cuts from Iran (160,000 bpd) and Libya (170,000 bpd) as a result of U.S. sanctions and domestic unrest respectively.

Saudi Arabia has said its output will decline even further this month as the kingdom attempts to avoid an accumulation of excess oil inventories.

By acting quickly and aggressively, Saudi Arabia and its allies hope to avert an extended period of over-production and a sharper drop in prices, and early evidence suggests they have succeeded.

ECONOMIC OUTLOOK

The biggest uncertainty is still from the global economic outlook, where OPEC acknowledged in its most recent monthly report that risks to world growth “remain skewed to the downside”.

If global growth slows further, the potential for an oil market surplus will re-emerge, and OPEC members will come under pressure to reduce output even further.

However, the organisation is hopeful the major central banks will respond to signs of an economic slowdown by becoming less aggressive in tightening monetary policy.

The result would be an easing of financial conditions, a weaker dollar, and a soft landing for the global economy and oil market in 2019. (“Monthly Oil Market Report”, OPEC, Jan. 17)

Most traders and hedge funds favour the soft-landing scenario rather than a hard-landing or a re-acceleration of growth. Fund positioning in the main crude and fuels futures contracts is close to neutral.

In practice, there are substantial risks in both directions.

Faster-than-expected growth would leave the market short of crude, hedge funds racing to rebuild bullish positions, and propel prices higher quickly, allowing OPEC to relax some of its recent cutbacks.

If the economy does slow further and slides into recession, however, prices and calendar spreads will come under renewed pressure, forcing OPEC to cut again.

In the current market, the supply picture looks comfortable, with plenty of spare capacity and Saudi Arabia acting as swing producer, so prices will be determined primarily by events on the demand side.

• John Kemp, Reuters