INSIGHT: Has OPEC failed to register the oil demand-driven dynamics?

23 April 2018 15:42 Source:ICIS News

LONDON (ICIS)--Middle East geopolitics have taken the front seat in the oil price rally, with supply and demand fundamentals at least temporarily subsiding to the background.

However, the question of OPEC exit strategy remains largely unresolved and, so far, the cartel has paid little attention to demand growth recovery, indulging instead the market’s fixation for crude inventories.

With OPEC poised to declare mission accomplished on its crude supply deal, bulls lead the global oil market again with Brent prices hovering around $70/bbl.

However, is OPEC's policy the key driver?

Oil traders are hedging against an expected price increase, signals from the options market indicate.

The volume of call options is increasing against that of put options, especially on June WTI, indicating a heavier push to lock in the right to buy rather than to sell.

Source: CME Group

In its February 2018 report, OPEC suggested that the call on its producers could exceed their output by about 600,000 bbl/day, prompting a number of forecasters to revise their price expectation.

At the time, some investment banks – like Goldman Sachs – thought that by targeting OECD’s five-year average inventories, OPEC would overshoot on tightening the market.

The signals from the options market would back this bullish view.

But the bearish view holds that, on the contrary, a fast-rising crude production in non-OPEC countries would outstrip global demand growth in 2018, tipping the market back to oversupply.

US SUPPLY
One problem is that the net effect of OPEC’s supply management on global oil prices is indistinguishable from other supply and demand shocks, including geopolitical disruptions, immediate consumption and precautionary demand.

The remarkable level of discipline and restraint among OPEC producers and their 11 non-OPEC allies – including Russia – has indeed supported a price increase.

However, the faster- and larger-than-expected response of US oil has kept the monthly Brent price lower by about $5/bbl, according to April 2018 estimates from Bassam Fattouh and Andreas Economou from the UK’s Oxford Institute for Energy Studies.

As a result, OPEC’s exit strategy from the current supply deal remains a largely unresolved issue, as well as the uncertainty over how long the 1.8m barrels taken off the market will take to come back in one form or another.

US production has already broken through the 10m bbl/day threshold, marking the start of a new expansion cycle of oil supply, which could reach 12.1m bbl/day by 2023, according to a recent statement by Fatih Birol, the director of the International Energy Agency (IEA).

Source: Baker Hughes, US Energy Information Administration (EIA)

“It appears a virtual shoo-in that OPEC and its non-OPEC partners will continue to limit production beyond 2018 and thereby continue the global oil destocking process”, said PVM brokerage firm analyst Stephen Brennock.

GEOPOLITICS
At present, heightened tensions in the Middle East have been supportive of oil prices, with the Brent front-month contract shooting up to $72.58/bbl on 13 April, up from $63.70/bbl, or 14%, since the start of March.

“It is quite obvious that, at the moment, fundamentals have been put on the back burner with geopolitics taking the lead as the key price driver”, said Brennock.

“I would put the current geopolitical risk premium at around $5-7/bbl.”

Interestingly, the market has witnessed a decoupling between the crude market and the stock market on the back of higher geopolitical risk: the equity and the oil markets no longer move in the same direction roughly since Middle East tensions again spiked.

As Greg Sharenow, a portfolio manager at US investment management firm Pimco, explained to ICIS: “I’m not saying that equity is not driving the oil market, but both markets have idiosyncratic drivers and we don’t think that oil prices are driven by GDP views at the moment [while equity is].”

Instead, two proxy wars have reignited the Middle East’s powder keg – that between Saudi Arabia and Iran in Yemen, and that between the US and Russia in Syria, driving oil prices higher.

Prices have also increased on growing concerns about possible outages in Saudi Arabia.

“A missile capability penetrating into Saudi Arabia could clearly impact output more directly,” said Pimco’s Sharenow.

Markets have also taken cues on the US Administration’s hawkish moves against Syria, Russia and, more importantly, against Iran.

Although buyers and sellers have already priced in the increasingly likely possibility of renewed US sanctions against Iran.

In fact, according to PVM’s Brennock, the Iranian issue would pose a major price risk to the oil market, potentially propping up prices further.

“I still think it represents a major bullish catalyst with the potential of pushing Brent past $75/bbl in the coming weeks,” he said.

The Joint Comprehensive Plan of Action (JCPOA) on Iran is coming for consideration very soon, and there is continued evidence from the US Administration that sanctions may come back.

“The US does not import oil from Iran, but some of our partners do and there is a possibility that the US Administration may pressure the shipping and banking industry to force our partners to comply with the sanctions”, said Sharenow.

Saudi Arabia has been key to the success of the supply deal, with OPEC effectively ending 2017 by reversing its revenues back to growth by 16%, according to Fattouh and Economou at the Oxford Institute for Energy Studies.

However, once concern for the kingdom might be whether Russia will uphold its end of the deal if the US maintains some sanctions.

A new raft of sanctions against Russia has notably targeted Vladimir Bogdanov, co-owner of Surgutneftegas, the fourth-largest Russian oil company, which produces more than 10% of Russia’s oil.

RESPONSIVE
In the US, the global crude oil market is now facing a new source of supply that has proven highly responsive to price signals and that has replaced demand at the centre of oil price dynamics.

In other words, the success of OPEC’s strategy has been largely demand-driven.

However, traders should also be paying more attention to US supply, which could cap any price increases.

Any slowdown in demand – due to higher prices – or sluggish economic growth will have a substantial effect on prices.

Therefore, any ‘mission accomplished’ rhetoric should be benchmarked against demand growth recovery rather than elusive and ill-defined inventory levels.

By Julien Mathonniere

By Julien Mathonniere