OPEC Output Cut Reignites Inflation Surges

4 Nis 2023

NYMEX: WTI (CL1!), RBOB Gasoline (RB1!)
Over the weekend, eight OPEC producers, led by Saudi Arabia, announced intentions to cut oil production by 1.16 million barrels per day through the end of the year. This adds to Russia’s existing plan to trim 500,000 barrels from February level, bringing the combined voluntary cuts of OPEC+ members in excess of 1.6 million barrels per day.

This surprise announcement is a supply shock and pushes oil price to its highest level in a month. On Monday. NYMEX WTI May futures contract opened at $80.1, up 6.1%, while refined products Heating Oil (HO) and Gasoline (RB) went up 2% and 3%, respectively.

Oil price hike adds to the risk of global economic slowdown. COMEX Gold is up 1% to $2,002. For a thorough analysis on gold, please read my recent writing:


Oil Price Elasticities and Oil Price Fluctuations
Crude oil is an inelastic commodity. When oil price goes up, the resulting decrease in demand will be less, in percentage terms.

In a 2016 research paper, Fed economists found that the short-run oil supply elasticity is about 0.1 and the oil demand elasticity is about −0.1. They also found that oil supply shocks are the main driving force of oil market movements, accounting for 50 and 40 percent of the volatility of oil prices and oil production, respectively.
(Source: “Oil Price Elasticities and Oil Price Fluctuations”, Caldara, Dario, Michele Cavallo, and Matteo Iacoviello (2016), International Finance Discussion Papers 1173.)

Let’s illustrate this point mathematically:
• Given: Revenue = Sales X Price, assuming sales = demand
• When price goes up 6%, sales would change by -0.1 X 6% = -0.6%
• New Revenue = (1+0.06) Price X (1-0.006) Sales = 1.05364 (Price X Sales)
• The percentage of change in oil revenue is +5.4%.

The economic reason behind the OPEC decision:
1) Supply shock pushes oil price up;
2) Higher price and lower production result in higher oil revenue.

This explains why the US has difficulty persuading OPEC to increase production. It runs counter to their core economic interest.

Investment Strategies in an Inflationary Environment
US consumer price index (CPI) rebounded 0.4% and 0.5% in the first two months of 2023. Annual inflation for energy products: Gasoline (-2.0%), Fuel Oil (+9.2%), Electricity (+12.9%) and Piped gas service (+14.3%).

Oil price surge raises energy cost globally, from transportation and utility to the cost of most goods and services. This adds to the uncertainly of central bank monetary policy. According to CME FedWatch, futures traders put 44.6% odds of no rate hike in the May FOMC meeting, and a 55.4% chance of raising 25 basis points. This is like flipping a coin.

However, there are opportunities on energy futures, if current price trend continues.

WTI Crude Oil (CL)
Since last year, the Biden Administration released 180 million barrels of crude oil from the Strategic Petroleum Reserve (SPR) to fight record gasoline price and runaway inflation. According to US Energy Information Administration (EIA), crude oil stock in the SPR stood at 371.6 million barrels at the end of January. This is the lowest level since 1984.

In a few weeks, the peak summer driving season will be here. This, coupled with the need to replenish the SPR, forms a strong demand basis for the remainder of the year.

With demand being inelastic and the OPEC having incentive to cut output further, I could see WTI going back to the $90-100 range.

July WTI (CLN3) is currently quoted $80.0 a barrel. Each contract has a notional value of 1,000 barrels. Margin requirement is $5,500 to place one contract. Hypothetically, if July futures goes up to $90, a long position in one July WTI contract would gain $10,000 (=10*1000). Theoretical return would be +81.8% (=10,000/5,500-1), excluding commission.

RBOB Gasoline (RB)
On April 3rd, American Automobile Association (AAA) reports that national average retail price for regular unleaded gasoline is $3.506 per gallon. This is up 6.7 cents or +1.9% from a week ago, and +11.6 cents or +3.4% from a month ago.

Current price is 68.6 cents or 16.4% below year-ago price of $4.192. However, with less supply and more demand on the horizon, I expect gasoline to retest the $4 level soon.

July RBOB (RBN3) is quoted $2.6575 a gallon. Each contract has a notional of 42,000 gallons. Minimum margin is $6,500. If futures price goes up to $2.9, a long position would gain $10,185 (=0.2425*42,000). Theoretical return would be +56.7% (=10,185/6,500-1).

Heating Oil (HO)
Heating oil price peaked during cold winter season in January. While it is a refined product, the cost of crude oil has less impact on heating oil in off-peak season. Therefore, I do not see much upside potential from current price level of 2.6665/gallon.

Henry Hub Natural Gas (HH)
OPEC’s output cut has no direct impact on natural gas supply. Today, HH futures went down 11.7 cents to $2.099 per 10,000 MMBtu, or -5.23%.

In the U.S., about 50% of the electricity is generated from natural gas, with the remainder coming from coal and renewable energy sources.

CBOT Corn Futures (ZC)
Currently, up to 40% of US corn output is used to produce ethanol, a form of biofuel. Oil price surge would boost the consumption of the lower-cost ethanol, holding everything else equal. I will write a separate paper on Corn futures next month.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

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