Oil has been at the forefront of the commodity recovery over the past couple of months. It goes into this weekend’s Doha meeting at a key chart level and potential for a “buy the rumour; sell the fact” response.

It’s impossible to disentangle the influence of the production “freeze” to be discussed by major producers at the Doha meeting from other recent positives for oil. These include progress on US production cuts; Janet Yellen’s recent speech on Fed monetary caution; a weaker US Dollar and signs that the lagged impacts of China’s stimulus initiatives are beginning to improve commodity demand.

 

Doha Meeting

 

To some extent, the Devil will be in the details when it comes to assessing any production freeze agreement – who is involved; what are the productions limits and what are the processes for reviewing and policing the agreement? OPEC’s poor track record of compliance with production agreements warrants a high degree of market caution.

However, the timing of any production freeze might be pretty good. It would come at a time when US shale production finally seems to be trending down again. Last week, it fell below 9m barrels a day for the first time in 18 months. This is down from a peak of 9.6m barrels.  Big cuts in capital expenditure budgets and the number of operating oil rigs make it pretty likely that US production will continue to decline over coming months.

If Iraq and other major producers outside Iran join the Saudis and Russia in formalising a production agreement, it will at least reduce the risk of other parties stepping in to replace lower US production. Iran clearly intends ramping its production up to pre sanction levels. However many analysts believe practical constraints will make this a slow process from now on. Iran has increased its production by 0.4m barrels to around 3.3m since sanctions were lifted. Further increases are forecast to require more extensive repair and rebuilding of plant.  If that’s right, falling US production and a freeze by the Saudis and others could see the supply side of the oil balance equation moving in the right direction.

It’s worth bearing in mind that Saudi’s decision to stop acting as a swing producer in 2014 was motivated largely by the lessons of the 1980’s. With the benefit of hindsight, the Saudi’s limited their production for too long during the 80’s. They were trying to support the price in an oversupplied market. All this achieved was to allow higher cost producers to replace them, increasing overall capacity. When the Saudis finally did open the taps to defend their revenues, it took the market 15 years to recover. This time around the Saudis saw the benefits of acting much earlier, allowing market forces to kick in and reduce global supply capacity faster once signs emerged of high cost capacity getting too large.

A production freeze agreement now might indicate that the Saudis now see the processes of moving towards a balanced market as being sufficiently advanced for them to agree not to ramp up their own production further. The latest forecast by the International Energy Agency is for the oil surplus to fall to only 0.2m barrels by the 2nd half of this year from 1.5m in the first half. This will come from a combination of 0.7m in non Opec production cuts and an annual 1.2m barrel increase in demand.

 

Oil chart

 

Whatever, the reason for oil’s rally over recent weeks, it means the market is goes into the Doha meeting with higher downside price risk. As often happens, oil is also around chart resistance going into the meeting. The risk ranges from a “buy the rumour sell the fact reaction” to any agreement to outright concerns about the implications of a failure to broaden the agreement beyond current parties.

The 200 day moving average has done a good job of defining the downtrend in West Texas crude since prices broke below it in 2014.  The average stopped the 2 major corrective rallies last year. We are now in the third major rally since 2014 .This one has nudged above the 200 day average.

However, price has run straight into potential resistance just above the 200 day average. This consists of the 61.8% Fibonacci retracement of the last major swing lower. Just above that, is the horizontal resistance formed by the trend lows and highs in October and November. Failure around these levels would make this week’s nudge above the 200 day average a false break, at least for the time being.

The other possibility of course would be a clear break above this resistance. From a chart point of view, that would be a bullish development. It could easily lead to the current rally extending towards the next major resistance around $48/$51.

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