What Russia and Saudi Arabia's new deal means for the oil market

Saudi Arabia and Russia's new deal to freeze production isn't fooling the oil market, says John Stepek. But as far as investors are concerned, that doesn't matter.


Saudi Arabia and Russia's deal lacks teeth

Russia and Saudi Arabia this week agreed to freeze oil production at current levels amid the global supply glut.

Well, they agreed to do it as long as everyone else agrees to do it too.

And the fact that they're currently pumping rather a lot of oil also renders the decision to "freeze" production a little bit toothless.

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Doesn't sound very effective, does it?

But maybe that doesn't matter.

A toothless oil deal

Both Russia and Saudi are already pumping at near-record levels, so this isn't really a huge sacrifice. And you do have the problem of keeping an eye on whether anyone is actually sticking to the deal or not.

In short, there's no reason to expect Russia and Saudi Arabia's pact to do much to the actual oil supply. As the FT points out: "The deal will not take a single barrel of oil off the market to ease the glut that has driven crude prices down by about 70% since the summer of 2014."

Iran has given the move a "cautious welcome" reports the FT, but it's not planning to join in, given that it has only just regained full access to world oil markets.

So in essence, there's not an awful lot of change to the oil market.

But I'm not sure that's what matters now, not from an investor's point of view.

You see, all that's happened is that Russia and Saudi have confirmed what everyone already knew. There's a lot of oil in the world and there's going to continue to be a lot of oil in the world.

This isn't news. It's now the received wisdom.

Before summer 2014, it was received wisdom that oil cartel Opec wouldn't allow the price of oil to fall below $100 a barrel. That seemed logical to lots of people. It was also rubbish. High prices (and cheap credit) encouraged producers to pump as much as they could. That drove up supply. So prices fell.

Today, the received wisdom is that there's an oil "glut". (There's an extra dollop of received wisdom too, arguing that the price is now capped by US shale production. This is one that I tend to agree with, but the widespread acceptance of this notion increasingly makes me wonder how it could be proved wrong.)

Producers haven't been able to stop selling oil, because they need the money.

But that state of affairs can only continue for so long too. The fact that Saudi Arabia and Russia are talking it's the first such deal between a member of Opec and a non-member for 15 years, says the FT demonstrates that producers are weakening.

The fact that the oil price rebounded following initial disappointment in the lack of a deal with teeth suggests that investors might be starting to think that too.

The contrarian trade right now reflation

However, I would be keeping an eye on the stronger players in the sector. And I also suspect that we could be due a broader "reflation" trade.

The big story right now on everyone's minds is negative interest rates, stagnation, central bankers failing to stimulate, China's slowdown, a US recession deflation, deflation, deflation.

The latest Bank of America Merrill Lynch survey of fund managers confirmed it. Managers are holding on to more cash than at any point since 2001. The most crowded trades are long dollar, short oil, and short emerging markets.

But in the background, we're seeing a stealthy turnaround in the mining sector. The Federal Reserve is soft-pedalling the idea of raising interest rates, at least for as long as the market is freaking out, which means the strong US dollar one of the biggest deflationary forces in the world for the last 18 months has topped out for the moment. There are tentative signs of an emerging-market rebound too.

As always in markets, when everyone's taking one view, it pays to be on the opposite side of the trade.

One sector in particular should do well from any reflation trade. My colleague Alex Williams will be telling you all about it in tomorrow's Money Morning.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.