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Oil traders are getting ahead of themselves. Reality is about to 'rear it's ugly head'

  • Oil prices have spiked on news that Saudi Arabia and Russia have agreed to extend cuts.
  • We think traders are reading too much into the news.
  • Here's why oil prices will head lower as reality sets in.
Workers at an oil facility near Riyadh, Saudi Arabia.
Hasan Jamali | AP
Workers at an oil facility near Riyadh, Saudi Arabia.

Oil prices have spiked once again on the news that Saudi Arabia and Russia have agreed that the current oil cut needs to remain in place beyond this year.

On one hand, this is good news because we are looking at a situation where we won't have to worry about oil production and its baggage for some time and the supply glut which has been building over the years could be reduced.

On the negative side, we are still concerned. We think that traders are reading too much into this situation and they are being too optimistic. The current production cut has not been able to produce substantial results so far in terms of limiting the glut, so extending the cut into 2018 may not have a big enough impact.

Moreover, the threat of noncompliance by the OPEC members who are agreeing to this production cut remains a viable risk for oil prices as countries like Iran continue ramping up their production. Even more critical, U.S. shale oil producers are taking the biggest advantage of the current situation by adding more oil to the global supply glut.

Therefore, to be completely optimistic about the future of oil prices rising above the $60 dollar level, we need two things: a bigger cut by OPEC and stronger global demand.

I do not think that the Cartel is ready yet to look for deeper cut. I believe it is trying to work with current production cut to yield results. For that reason, it is aiming to extend the current production cut beyond this year.

This is not going to cut the mustard, because the biggest problem will most likely emerge within the cartel. Libya and Nigeria are ramping up production massively. This is going to have an impact on the overall number for OPEC oil production.

Best case scenario, I see the markets celebrating in the short-term the fact that extending the production cut could lessen the supply glut, but I expect reality to rear its ugly head sooner rather than later. It would be then that we could see the price dropping once again.

In order for the price to move significantly higher, we need to see more strength in the global gross domestic product growth. Under the current circumstances, where in the biggest economy of the world the GDP has only grown by 0.7 percent during the first quarter of this year, the signs are not positive, especially if you consider that the global growth has not seen any major shocks.

If we look at the data coming from China, the second biggest economy in the world, things are lukewarm over there too. The economic softness continues. When it comes to global growth, I would say that it is currently stabilizing at best, but far from roaring.

Therefore, I believe that the odds are against the price of oil touching $70 anytime soon. It is highly likely that we would continue to consolidate between $40 and $60. For risk averse investors, the ideal scenario could be to look for an entry when the price is trading in the low $40s and look to take profit when it is in mid $50s.

Commentary by Naeem Aslam, chief market analyst at ThinkMarkets. Follow him on Twitter @NAEEMASLAM23.

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