Oil bubbles up as OPEC+ disagreement could cause major undersupply
Oil prices are rising further today, as the breakdown in OPEC+ negotiations is making the possibility of not adding output in August very real, and is a potential development that not even the most bullish of traders could envision a week ago.
The situation can still change of course and prices can normalise as unofficial talks are always ongoing and there could be a sudden breakthrough, but the lack of an official new meeting date is worrying the market which is now rushing to re-price portfolios ahead of a possibly super-tight August.
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For the moment, the OPEC+ impasse remains cemented with little manoeuvring from any of the involved parties, and as prices are rising the tightness of the physical oil market is being tested.
The indecision of OPEC+ has generously lifted all oil benchmarks, but none more in relative terms than WTI, which is narrowing its difference versus Brent, boosted by a whiplash demand recovery speed in the US economy.
The lack of a sufficient supply response from shale operators in North America, who have kept spending rather conservative despite the bullish price environment, was expected to be met by more OPEC barrels – which now seems to be a less likely scenario.
Traders are now scratching their heads over how US demand will be satisfied without more international barrels, and the immediate response is WTI, the local most accessible supply. As WTI supply is not ample, the benchmark is today seeing a significant price boost.
While a tighter crude market is justified, the current price environment is largely exaggerated by market excitement, but more so, uncertainty.
If OPEC+ does not raise August production, the market should expect much larger inventory draws than what was so far anticipated. This is a bullish development, especially as demand is expected to grow by at least 2mn b/d between now and August.
The imminent demand spike should be a justification good enough for OPEC+ to kink out a supply increase deal.
However, it is just as likely the group takes a step back and revisits its supply quotas at the August meeting – once there is more data on the demand destruction of the Delta variant and progress on the Iran nuclear deal.
The nuclear deal itself may become a bargaining chip in chartering a new OPEC+ deal with new benchmark production quotas, that could include more leniency towards the OPEC+ members like Saudi Arabia and the UAE which have done much of the heavy lifting of the deal in the past 13 months.
Setting new quotas could also provide an opportunity to include the current non-contributors of Iran, Venezuela, and Libya.
Looking at the current deadlock, It is unlikely that the UAE alone will be allowed to get a higher quota, because this will come at the expense of other members, in particular Saudi Arabia.
Another very real consideration is that many of the OPEC+ countries, Russia in particular, are facing natural decline in the medium-term, so a lower quota in some cases could be strategic for long-term revenues.
The OPEC+ impasse is an example of Icarus flying too close to the sun – a sizeable supply deficit in the market will stoke prices in the short-term, potentially above $80/barrel Brent, but could also be setting the stage for an oil price crash similar to what the market experienced in November 2018.
In the summer of 2018, by then a duopoly power spearheaded by Saudi Arabia and Russia, OPEC+ was able to stoke oil prices to $82 Brent by October 2018, which was a short-lived high as the loose supply policy resulted in prices dropping to $58/b in late November 2018, which forced OPEC+ to come back to the table and announce a more than 1.2mn b/d collective supply cut.
The current OPEC+ spat highlights not only the fragility of the market in a specific Covid-19 context, but also the broader animosity brewing between the group of 23 nations that are forced to come together to manage the market, but of course have direct competition interests in selling their oil at the highest price for the most sustainable time period.
Lastly, the market should not forget that there are real pockets of weakness as the Delta variant hits road and air traffic demand.
China is already witnessing a rapid increase of active cases and enforcing mass lockdowns, and road traffic levels have already fallen to 87% of pre-COVID-19 levels.
More pronounced downward oil demand pressure is visible in countries like Taiwan, where strict lockdowns have resulted in the road traffic index plummeting down to 66% of 2019 levels, the deepest drop registered since the start of the pandemic.
Louise Dickson is Rystad Energy's oil markets analyst.
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