Another turbulent week saw oil prices falling hardest since March. The downbeat mood is down to a combination of factors or to the usual suspects, one might say. The Delta variant of the virus is spreading in several parts of the world raising economic growth concerns. Fears of inflation and therefore of interest rates rise have re-surfaced. Finally, future oil supply is currently uncertain.
Coronavirus: despite the roll-out of inoculations programmes several countries have been forced to re-introduce mobility restrictions. The Philippines recorded the first locally acquired case of the Delta variant leading to authorities to re-impose strict measures. Daily death toll in Indonesia reached a record on Friday. Wearing masks is mandatory again in Los Angeles. The Tokyo Olympics is about to kick off in front of empty stadiums and sports halls due to a state of emergency. South Korea is pondering on introducing tighter limits on private gatherings. The global Covid situation is turning dire again and it understandably makes investors wary although it must be stressed that restrictions are being eased in other parts of the world.
Inflation: both US consumer and producer prices increased last month. The Consumer Price Index accelerated 5.4% year-on-year and 0.9% on the month in June, the biggest increase in 13 years. Producer prices posted their biggest annual gains in more than 10 years as they ballooned by 7.3% in June. Jerome Powell, the Fed chair, however, is undeterred to continue with the current monetary policies. Although he acknowledges that upside price pressure could remain elevated for months to come, he reiterated his stance at a congressional hearing that the spike in prices will be transitory. The easing of inflation in the eurozone that slowed from 2% in May to 1.9% in June might serve as a justification for his resilience. The US 10-year Treasury yield fell last week.
Oil supply: it is all about OPEC+. After two weeks of hiatus and stand-off the UAE and Saudi Arabia have come to an agreement to revive the next phase of the output deal that was put on hold at the beginning of July. The Emirates’ wish of a higher production base line was granted in return of agreeing to extend the supply cut deal beyond the April 2022 expiration date. OPEC’s third-largest producer will see its baseline increase to 3.5 mbpd from next May, less than the 3.8 million it initially demanded but above the previous baseline of 3.2 million. The group will now increase supply by 400,000 bpd on a monthly basis starting in August and set a target for the end of next year to completely phase out its 5.8 mbpd production adjustment.
The view here is that potentially removing Damocles’ sword from above the supply market is a positive development, yet the news was greeted with a substantial sell-off. Unequivocally, last week’s price fall was driven by supply consideration. Stock markets held up reasonably well, and commodity indices were also stable. The Reuters/Jefferies CRB Index finished the week marginally higher whilst WTI, which has a significant weight in the index’s basket together with the other oil futures contracts, lost 3.7 % during the same period. Brent shed 2.6 % of its value. Assorted time spreads of the two crude oi benchmarks have also weakened significantly. The M1/M6 WTI spread fell 1.55 cents/bbl whilst its trans-Atlantic cousin cheapened 78 cents/bbl – possibly due to the monthly rolls rather than because of growing fears of immediate swelling of global oil stocks. Oil will probably dance to the tune of supply side developments in the foreseeable future.
Next year’s oil balance hangs on OPEC+
The latest estimates of supply and demand from OPEC paints an upbeat picture for the future – more so for 2021 than 2022. The balance of this year is bullish, based on current projections and available information. It will be tight, tighter than it has been if global oil demand grows at the rate it is expected to expand and even accounting for the easing of OPEC+ supply curbs. At the end of May OECD oil inventories were 86.6 million bbls below the 5-year average and 21.7 million bbls lower than the 2015-2019 average. Further stock erosion is pencilled for June. The latest OPEC report suggests that global stocks will deplete at the rate of around 1 mbpd in 2H 2021. Assuming 40% of it takes place in the developed part of the world inventories in OECD countries ought to break below the 2.8 billion bbls support level. By anyone’s standard this implies a very tight market, which is one of the reasons why the current weakness should be just like US inflation – transitory.
Next year oil demand growth is set to outpace non-OPEC supply expansion resulting in a 1 mbpd year-on-year increase in OPEC call. The first half of the year will be somewhat sluggish (demand for OPEC will stand at 27.1 mbpd), but 2H will see a significant improvement where the world will need 30.25 mbpd oil from OPEC. This suggests an easy path to walk along for the producer group to fulfil its balancing role in the oil world.
There is, however, a catch. Baselines for several other producers within OPEC+ were also revied higher. While it is said that this won’t alter the pace of monthly production increase, future demands to effectively further boost oil production could easily upend the currently optimistic 2022 outlook. Up until now every participant of the OPEC+ group shared the burden of the output restraints proportionally. The June quotas, for example, were 15% below the baseline figures for each and every country. A quick calculation shows that in case the rest of the group would demand the same increase in base line as the Emirates (arguing that only this would ensure fair and proportionate burden sharing) OPEC+ output level would grow by 6 mbpd above last month’s ceiling meaning that the remaining output constraints of 5.8 mbpd would be completely wiped out. Whist we are not saying that this will be the case, the UAE’s demand sends out a warning signal that the producer group will face a tricky balancing act to mutually satisfy its own members as well as the wider market next year, after a successful 2021.