LONDON (ICIS)--The global crude oil glut is on the wane, although not necessarily as the direct effect of OPEC’s supply management efforts: The loose collective agreement may have supported market sentiment, but it is tearing at the seams.
Unplanned disruptions throughout 2017, along with expectations for higher demand in 2018, have helped fundamentals realign more than any other proactive policy.
Meanwhile, given the lower OPEC spare capacity, markets might have insufficiently priced higher geopolitical risk, especially if a major supply outage were to happen.
As developed economies put the break on quantitative easing and move into a new cycle of tightening monetary policies, there is hope that the higher borrowing costs may also mitigate the producers’ lower break evens and prevent another supply boom.
Excluding Saudi Arabia and the Gulf, cut compliance has been loose
Over the past year, OPEC has shown a remarkable degree of cohesion and drawn even non-OPEC producers, including large ones like Russia, into its production curtailment deal.
The global oil market is in a better position today than it was 12 months ago.
However, the causality between those two events may prove more difficult to establish than headlines suggest; even less so if we consider the fact that OPEC has failed to meet its production-curbing target in six out the 12 months the agreement has lasted so far.
OPEC has been in a defensive mode, but the reality is that some members have continued to export more crude after the supply pact was agreed.
Meanwhile, the most efficient and cost-disciplined US shale oil producers have enjoyed relatively low capital costs that have supported a higher output on lower marginal production costs, hence filling the vacuum left by the missing OPEC barrels.
Saudi Arabia has endured most of the cuts, with close allies like the UAE and Kuwait folding in.
Other OPEC members have been more reluctant to curtail their production, especially those facing mounting levels of internal debt.
Among them, Russia has proven a crucial if only unwilling ally from whom the best OPEC could expect was a freeze of production growth.
This partly explains why Russian production was frantically ramped up to unprecedented levels shortly before the agreement in November 2016, but this did not stop Russian crude exports volumes to keep increasing throughout 2017.
Kazakhstan, another large non-OPEC producer, has said that it might be complicated to comply with the extended agreement. Its prolific Kashagan oil field, a $50bn offshore development in the Caspian Sea, came online 10 years late and is still plagued by recurrent technical issues, prompting the urge not to delay the cash flows any longer.
As a result, the incentive not to cooperate remains stronger, especially for smaller producers whose cheating is unlikely to affect the global prices in a significant way.
They can still produce marginal barrels at their own break-even price, which is likely to be above the OPEC production cost.
Saudi Arabia produces one out of nine barrels of oil and has the lowest production costs, hence pulling the OPEC break-even costs below the other members’ thresholds.
Is backwardation really the solution?
The Brent and WTI term structures have both since moved into backwardation, in line with a reduction of OECD crude inventories.
However, a larger-than-expected demand growth in 2018, along with a disruptive hurricane season in the US in 2017 have been the key drivers of that change, rather than OPEC’s collective effort.
“By drawing down inventories and shifting the forward curve into a level of backwardation […] you take away that ability for higher-cost producers to hedge”, said US investment bank Goldman Sachs’ global head of commodity Jeff Currie.
OPEC low-cost oil producers can hence sell their output at a higher price linked to the spot market.
Backwardation has a downside though: there is little incentive to destock if producers/sellers can still hedge their inventory storage at break-even costs.
Crude stocks already funded by the market and thus hedged from a producer’s perspective may become even more valuable because in the end, holding a commodity in storage remains a better deal than converting it for cash and parking it in low yielding bonds.
Therefore, investors holding large crude inventories will need a much steeper backwardated forward curve and higher spot prices to destock.
OPEC management is not the key driver of price
OECD Europe and China will be the key drivers of global oil demand growth in 2018.
Recent data pointed to a healthy winter demand from China, and it also underlined that Chinese refinery runs and storage levels had been underestimated, hence an expected 500,000 bbl/day demand growth in 2018.
Market sentiment and the US has now a much bigger role than before, explaining why participants have been focused as much on OPEC announcements than on US weekly stocks and rig count.
OPEC’s influence on prices has become dependent on the expectations of these participants and how they interpret OPEC signals.
In standard signalling models, informed agents communicate private information indirectly via choices of observable actions. Because the choices made are costly, signalling becomes credible.
However, OPEC communication with the market is directly through public announcements and, therefore, OPEC signals are without cost.
This raises the question whether OPEC intents can be credibly transmitted to the wider market.
In 2018, the question might not be so much who produces the marginal barrel as to whether US shale oil production will outstrip global demand.
At present, global crude stocks still stand at 13.2% above their five-year average, the OPEC’s target. Meanwhile, US shale is producing about 9.71m bbl/day, which represents a six-year production high.
Source: OPEC, US' Energy Information Administration (EIA)
Increased geopolitical risk may put a premium on prices
Increased geopolitical risk has helped markets refocus on physical supply fundamentals, with the potential for more disruptions in 2018.
Oil prices could spike if major oil producers like Venezuela, Iran, Libya or Nigeria were included in the turmoil. If not, and even if the effects of a future crisis remained localised, the higher risk premium could still affect commodity prices as whole.
Rebounds from producers like Libya and Nigeria, both exempt from the production cuts, have also kept diluting OPEC’s efforts despite them joining the latest round of cuts.
On the upside, Venezuela’s flirtation with a default risk has already been priced by the market but if it were to materialise in 2018, the effects would be strongly felt throughout the global oil markets, even if the country produces a heavy sour type of crude that is mostly used for blending by US refiners.
Venezuela desperately needs higher prices to restore its fiscal position but could contribute unwillingly if the government collapsed.
China is still characterised by a highly leveraged economy and hence a large debt overhang, which may prompt some monetary tightening in 2018.
Average China’s GDP growth expectations still stand at between 6% and 7% for 2018, and the oil markets continue to actively track imports quotas from independent refiners, a good outlet for excess crude supply.
In 2018, China will also introduce its petro-renminbi with the launch of an oil contract denominated in Chinese yuan by the Shanghai International Energy Exchange.
The global futures market for oil trading has been underpinned by the two ruling dollar-denominated benchmarks of West Texas Intermediate (WTI) and Brent crude, with a combined daily turnover of more than 2bn barrels – or about 20 times the total daily world oil demand.
The demand for Chinese yuan may increase as result, as the cost of the US dollar. Key oil exporters to China like Iran and Russia are already more than happy to transact in yuan terms.
China has also become Iran’s main crude oil customer, signalling that the Islamic Republic might be reluctant to cede any market share to Saudi Arabia after facing difficult restructuring decisions at the height of US sanctions.
Middle East geopolitics has nonetheless improved, not least as the result of Mohammed Bin Salman power play in Saudi Arabia, and its push for a change that will help the kingdom’s transition to a post-oil future. However, this comes at the price of heightened tensions with Iran.
Market sentiment may find stronger anchorage in macro fundamentals
Assuming OPEC compliance remains minimal, the crude and refined products markets should be broadly balanced in 2018.
Adding to the lack of US refining capacity for light sweet oil, the wider WTI-to-Brent discount has prompted increases in US oil exports.
The higher the price now, the more oil will hit the market. Not only US oil, but also oil from unconventional deep-water oil players, or heavy tar sands from Canada, the cost of which are now well below the fiscal break evens of some OPEC countries.
Markets have been transfixed by the US crude inventories and rig count, responding strongly to very slim evidence of changing supply and demand fundamentals.
Fears of a resilient US shale oil industry keeps dragging on market sentiment.
At the macroeconomic level, investors expect more advanced monetary tightening to mark the closure of a cycle of quantitative easing. Not only the US Federal Reserve, but several other central banks in OECD countries will probably raise their policy rates in 2018.
In fact, more tightening than is currently priced by the market is a real possibility. If that happened, the resulting increase in the cost of issuing debt could once again rein the borrowing spree among US oil producers and, in turn, limit the upside of US shale production.
This would support the oil price by reasserting market discipline and forcing independent producers to refocus on profitability rather than production volumes.
Crude is receding in the world energy mix
A spike in global commodity prices is not excluded, but it will stem from higher supply disruptions or, more likely, from low capital expenditure (capex) across the oil sector as a whole, in particular to develop new reserves and mitigate natural production declines.
An increasingly acute issue is that oil, on a worldwide scale, is now effectively just a transportation fuel.
Crude oil demand growth over the five past years has come essentially from jet fuel, gasoline, and petrochemicals feedstock.
The lower end of the barrel used by industry, in particular by power generation, is no longer there or no longer as much in demand as before.
Oil has held a monopoly in the transportation fuel mix, but transportation is set to change dramatically in coming years. Not only because of efficiency, but also because of demographics, preference of drivers, and changing applications from gas and electricity.
As a result, the intensity of crude oil relative to GDP is falling at a faster rate than everyone had thought.
Traditional fossil fuel users are switching to cleaner, lower-carbon alternatives, compelled by growing concerns for air quality and the urge to tackle climate change.Source: The Shift Project Data Portal
The idea to ban the combustion engine in the next 10 or 15 years might still be far stretched, but about 50m electric vehicles might roam the roads in OECD countries by 2025, and up to 300m by 2040, from only 2m today.
Even if this may only affect the passenger car and power segments, it implies that OPEC has somehow already lost the fight to keep oil prices high.
Pictured: Pump jacks in Alberta, Canada
Source: Design Pics Inc/REX/Shutterstock