Why the oil markets made a U-turn

May 29, 2018

Last week the oil price did a U-turn based on expectations of production increases by an alliance of OPEC and non-OPEC countries. Brent had tested the $80 level over several weeks. It fell to $76.44 by Friday and some more in early Asian trading on Monday, reaching $74.50.

Over the past few months the rise of the oil price seemed unstoppable because of sharp production falls by Venezuela and the geopolitically tight situation in Nigeria, Libya and Northern Iraq. President Donald Trump’s announcement that the US was withdrawing from the Iran nuclear agreement, followed by the toughest sanctions ever, was the proverbial straw that broke the camel’s back and $80 seemed to have become the new level.

Trump issued a harsh tweet in the direction of OPEC, criticizing its production cuts for high oil prices. The International Energy Agency (IEA) and other pundits started talking about demand destruction and US consumers feared for their outings during the summer driving season.

Demand destruction is always a fear for producers, regardless of whether it is consumption induced due to higher oil prices or structural in the form of new technologies

The situation had indeed become tight. By January 2017 OPEC and the 10 non-OPEC countries had vowed to take 1.8 million barrels per day (bpd) out of production under the so-called “Declaration of Cooperation.” The aim was to reduce the huge global overhang of crude inventories by OECD countries to their five-year average. By March/April that mission was accomplished, which resulted in markets reacting nervously with each and every geopolitical glitch — of which there have been many this year.

Saudi Energy Minister Khalid Al-Falih and his Russian counterpart Alexander Novak met last week to discuss the situation. April compliance under the Declaration of Cooperation stood at 187 percent, which Novak calculated as overshooting the cuts by a million barrels. He felt that something needed to be done. Al-Falih, who is a hawk and on record as saying that he preferred markets tight, relented. They have agreed to address the issue and all eyes will now focus on next month’s OPEC meeting in Vienna.

Which country increases by how many barrels a day will have to be negotiated carefully, so as not to upset the delicate balance among OPEC producers.

Cornelia Meyer

Russia is currently talking of an increase of 250-300,000 bpd. But they have more capacity. There is new built capacity of around 700,000 bpd, which some players, especially Rosneft’s Igor Sechin, are eager to release.

In OPEC, Saudi Arabia, the UAE, Kuwait and Qatar have spare capacity. Saudi Arabia produces 9.9 million bpd and sits on a capacity of 11.5 million bpd. Which country increases by how many barrels a day will have to be negotiated carefully, so as not to upset the delicate balance among OPEC producers.

The IEA had also forecast non-OPEC production to increase by 800,000 bpd in 2018 — the lion’s share coming from North America. Earlier in the year the US had experienced some infrastructure bottlenecks in bringing shale from the Permian to the international markets. They seem to be addressed one by one. In June China is scheduled to receive the largest ever crude imports from the US.

We can be certain that OPEC will raise production in June, as will Russia. Saudi Arabia, especially, has every interest to do so, because it lost market share and may by now feel the need to preserve some of it, particularly in Asia. Russia has replaced the Kingdom as the biggest importer to China and Iraq has taken the top spot in India. The US is set to overtake Russia as the world’s largest producer this year, which means it will also be chasing after incremental barrels in the juicy Asian markets.

We can look forward to production increases from OPEC as well as its non-OPEC allies, and there are further barrels hitting the markets, particularly from the Western hemisphere. This will ease pressure.

However, in the long run we are not out of the woods yet: The sector as a whole is severely underinvested. The ultra-low prices in 2015 and 2016 had the big international oil companies cancel up to 40 percent of their scheduled investments. Last year they were still skittish when it came to investing. Conventional oil is a business with an ultra-long cycle and a dollar invested in upstream today will result in a barrel produced in four to 10 years.

By 2020 we could well start to feel the pinch. All depends, of course, on demand (currently forecast to grow by 1.4 million bpd, according to the IEA), which in turn will depend on the state of the global economy.