international analysis and commentary

Between two paradigms: An oil market snapshot

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The past two years or so have witnessed dramatic swings in the global oil market. Oil prices (Brent) dropped below $30 in early 2016 amid a massive supply/demand imbalance and swollen global crude and product inventories doing their best to absorb the excess. It was the persistence of low prices, and accordingly lower revenues for producers, that set the stage for agreement in December 2016 on the first global oil pact encompassing OPEC and key non-OPEC producers (most notably Russia) in over 15 years. Despite skepticism that the “OPEC+” alliance would endure, let alone prove effective, it has succeeded in bringing global oil inventories to their five year average, down from the 340 million barrel global inventory overhang facing the market at the start of 2017.

The OPEC+ alliance’s task has been aided by a number of forces, most notably prolific global crude oil demand growth, which has averaged 1.7 million barrels per day (bpd) since the 2014 collapse in global prices, double the rate seen in the early 2010s. Moreover, OPEC+ deal compliance, indeed over-compliance, has been made easier by precipitous declines in production by OPEC member Venezuela, which has lost approximately 800,000 bpd since 2015, and is currently producing 550,000 bpd less than it is permitted to under the OPEC+ agreement. The month of April saw a cumulative cut of 2.7 mmbd when the nominal OPEC+ target was 1.7/1.8mmbd. Declines are also evident across Angola, Brazil, Mexico, and a range of large international projects that have seen underinvestment in recent years.

Re-balanced, though hardly in repose, the oil market now faces an apparent inflection point. With Brent touching $80 per barrel in mid-May, some see this as a high-water mark before oil retraces its steps to settle $10, $20, or $30 lower for the remainder of 2018. Others see the end of the “lower for longer” oil market paradigm that has held since 2014, and anticipate prices of $100 or more within a year’s time. The foundation of these divergent perspectives is a litany of uncertainties – both in market fundamentals and in geopolitics – that are poised to evolve, some to their denouement, in coming months. A review of the countervailing forces present in the market today is illuminating.

The forthcoming reimposition of US sanctions on Iran is certain to lead to at least some measure of decline in Iranian oil exports. However, the Trump administration’s approach to enforcement of the sanctions – including the use of so-called “secondary sanctions” on European and other non-Iranian actors that Iran depends upon for oil trade investment, finance, and insurance – is likely to determine the degree to which Iran’s production and exports see absolute declines rather than re-shuffling to markets in China, India, and elsewhere. If the US allies among Iran’s oil importers – namely the EU, Japan and South Korea – adhere with US Treasury Department requirements to show significant reductions in Iranian imports every 90 days, then anywhere between 200,000-400,000 bpd could be taken offline by the end of 2018.

Perhaps more significant for the market, though occupying less headline space, are new sanctions against Venezuela following President Nicolas Maduro’s re-election that was deemed illegitimate by the United States and a number of other countries. The new US sanctions, which prohibit a number of different transactions with Venezuela but do not directly target the country’s oil sales, seem tailored in such a way as to exert pressure without spooking oil prices. The ultimate net effect is the subject of debate, with some analysts expecting Venezuela’s production to fall by 500,000 bpd to less than 1 million bpd total by the end of 2018, while others anticipate a more measured decline. Between Venezuela and Iran together, a wide range of possibilities – anywhere between 200,000 bpd to nearly one million bpd – could come off the market over the remainder of the year. Still unclear is exactly what scenario is assumed by the market’s current pricing, but the two countries together represent an upward pressure on prices.

Also providing an upward push to global oil prices may be the approaching implementation of new rules on maritime fuels. Maritime fuels account for around 5 million barrels, or around 5%, of global oil demand, and new specifications issued by the International Maritime Organization on sulphur content in such fuels will result in increased demand for gasoil as a quick, easy alternative to higher-sulphur fuels currently used in the shipping sector. The spike in gasoil demand, which should be supportive of crude prices, will have an uncertain duration, however, as increases in gasoil prices may encourage some to pursue alternative compliance strategies, such as switching to liquefied natural gas-powered engines or installing scrubbers and reverting back to dirtier – and less expensive – fuels.

In the United States, the Permian basin has become over the past year the workhorse of the American shale response to rising prices. Monthly Permian oil production growth has registered around 70,000 bpd recently, though this is threatened by infrastructure bottlenecks that have limited the ability of Permian production to reach markets. The discount being experienced by Midland WTI – a crude benchmark associated with a significant amount of onshore US shale production, notably in the Permian – versus Cushing WTI – the largest US crude benchmark, has breached $18 in recent days. With Cushing WTI itself trading at nearly a $10 discount to the other major global crude benchmark, Brent, this now means that some Permian producers are seeing nearly $30 less for their barrels than those producers with access to Brent prices.


A dwell in the Permian basin

This scenario is even worse for producers with infrastructure constraints that have hedged a significant portion of their production, as many did in the final quarter of 2017 through the first quarter of 2018. For these producers, who likely hedged production at somewhere around the then-prevailing WTI futures price of $50-$55 per barrel, the current Midland discount means that they may be seeing prices around $40 less than competitors that enjoy exposure to current WTI Cushing spot prices and the pipeline contracts necessary to access it. The price chasm is even greater if one were to compare them with producers exposed to current Brent spot prices.

With new pipelines that can alleviate the bottlenecks not slated to start coming online until later in 2018, the desperation of producers to get oil to market can be seen in the explosion of rail and truck traffic carrying crude out of the Permian basin, or in the boom in demand for “drag-reducing agents” that help lubricate pipelines for additional throughput.

Global oil demand is of course the other side of the price prognostication coin. Previous rising oil price environments have given way to demand destruction, and the International Energy Agency recently revised down slightly its 2018 demand growth expectation to 1.4 million bpd. With the global market heading into the summer driving season, typically leading to a perennial peak in demand, many market watchers will be looking for indicators of what today’s comparatively high prices – up around 30% since the beginning of the year – augur for demand. With more diverse transport options – from ridesharing platforms to fuel efficient and electric vehicles and beyond – available than ever before, it remains to be seen how, and how fast, consumers respond to the present moment.

In any case, a rising oil price environment eventually leads to domestic political discomfort in major oil-consuming countries, evidenced already in the United States by opposition politicians staging photo-ops or videos in front of petrol pumps. These dynamics are not lost on President Trump, who issued a perplexing, though politically astute, tweet in early May warning placing the fault for rising prices at the feet of OPEC. Clearly watching were the putative leaders of the OPEC+ coalition, Russia and Saudi Arabia, who have signaled that they expect to coordinate for additional spare production capacity – as much as one million bpd – to be brought online pending a formal decision at the key oil producer meeting in Vienna, on June 22. Such a move might not require any reform to the existing production cut agreement, but instead a series of measures to bring compliance back down to 100%.

Despite its day-to-day volatility, the oil market is likely to enjoy something of a brief respite from the storm as summer approaches. Iranian negotiators are on a world tour, seeking to determine whether they desire to patch and preserve the JCPOA, or abandon it entirely. US shale production continues to rise and rail and trucking contracts are being struck, with the worst of the Permian pipeline bottlenecks yet to bite. Venezuelan production continues its fragile dance, with the US entertaining, though not yet exercising, options for more aggressive sanctions.

Meanwhile, the OPEC+ alliance that has set the table for the recent run-up in prices now looks to be as critical as ever, talking down the market recently through rhetoric. Even if Saudi Arabia and Russia do end up pumping more crude, the initial relief to oil prices will likely be met by additional questions: Does this leave the world with much spare capacity at all?  What would happen if a new, unforeseen collapse in production somewhere around the world were to manifest? There are plenty of factors that could alleviate prices in coming months, but there also exists a very real possibility that the global oil market is sleepwalking into a supply crunch of unknown duration.