Natural gas and LNG rally, lifting the state of emergency in Japan, fuel shortage in the UK and fears of struggling output growth. Is it the recipe for a sustained run above $80/bbl basis Brent? The market certainly thinks so. Inflation, tapering, dollar concerns and stuttering economic growth have all been swept under the carpet and oil was driven by supply and demand considerations yesterday. The European benchmark missed its long-term target by 10 cents/bbl yesterday but is making amends this morning.

Not even a tepid stock market performance and a resilient dollar were able to dent the underlying optimism, which is based on the perception that the global oil balance will tighten in the foreseeable future. On the demand side it now seems almost inevitable that galloping natural gas prices will provide additional support to the oil complex. ICE next-day natural gas futures rallied almost 10% yesterday whilst the CME contract even more. The move higher continues this morning. The lifting of the state of emergency in Japan at the end of the month, rising Indian crude oil imports and the consensus at the APPEC conference in Singapore that oil consumption will reach pre-pandemic levels early next year have all provided ample ammunition for bulls who have not been shy to use it.

On the supply side of the equation the impact of Ida will probably be felt for longer than anyone would have anticipated. Analysts surveyed by Reuters put last week’s US crude oil stock draw at 2.3 million bbls on average. The queues at UK petrol stations are not the function of actual supply shortage, they are more of the predictable and unavoidable consequences of the health crisis and Brexit and the modus operandi of the government (any government for that reason) that excels at crisis management but not so much at heeding the warnings of industry leaders. Yet, the sense of undersupply is magnified by the panic buying and the idea of rationing.

The question is not whether the oil market is on the ascent. It is. Supply is not able to catch up with demand. Brent has risen $15/bbl or 23% in a month. The question is how long this bull run will last. If the view discussed below proves accurate then bears will not have much joy in months to come.

Overstated spare capacity?

The plan has always been to gradually ease the unprecedented output constraints introduced last May after the ill-fated Saudi-Russian price war that sent the price of the US crude marker to negative territory. OPEC+ members restrained from producing as much as 10 mbpd in 2Q 2020 and this planned supply deficit was set to be leaked back to the market step by step as global oil demand recovers. After the demand destruction caused by the health crisis it was the only sensible things to do to help global oil inventories fall and support prices. As demand has grown by nearly 5 mbpd from 3Q 2020 to 3Q 2021 (IEA data) the producer alliance has flexibly stuck to the original idea and has been increasing supply usually slightly lower than the call on its oil. Consequently, OECD oil inventories fell to 2.850 billion bbls by July this year, down from 3.179 billion bbls at the end of September 2020.

The trend, in theory at least, is set to continue well into 2022. Combined production ceiling that was 38.094 mbpd in July is expected to increase by 400,000 bpd every month until the reference production level of 43.853 mbpd (which will be revised up to 45.485 mbpd effective May 2022) is reached. In other words, the agreed mechanism of topping up monthly output by 400,000 bpd should last until September 2022. During the next year or so global oil demand will have risen by another 3 mbpd so OPEC+ output increase seems vindicated even if it is more than the forecast growth in global oil consumption.

It is, however, not a dead cert that OPEC and its partners will continue with the monthly easing of the supply constraints as planned. Firstly, as indicated above, the scheduled tapering could outpace the growth in oil demand leading to a rise in depleted stock levels. This might force the group to re-think its strategy and put the current plan on hold, especially if prices start falling in the face of rising stocks to levels that would put unbearable burden on the budgets of producing nations. Secondly, the first point might never come into focus because output growth of the OPEC+ group could have its natural limits.

The alliance has been admirably disciplined in its effort to bring down burgeoning stocks and re- balance the global market. Almost every month the adherence to the output ceiling was 100% – OPEC members have been proven more successful in complying than their non-OPEC peers, but the combined conformity level has usually been impressive. What is, however, noteworthy is that several producing nations, especially the smaller ones in dire need of petrodollars, reached unintended high compliance levels.

In the OPEC group Nigeria and Angola stand out. Output from the former was 225,000 bpd below its allowed quota whilst the latter fell 223,000 bpd short of the allowance last month, according to independent consultants and researchers called secondary sources. These figures equate to conformity levels of 240% and 214% respectively. Congo and Equatorial Guinea produced 102,000 bpd below their combined ceiling – these are compliance levels of 185% and 163%. Iraq has managed to fulfil its quota but additional production increase in months ahead is highly questionable. In the non-OPEC segment Malaysia’s adherence to the agreement stood at 233% in August (-100,000 bpd) whilst Kazakhstan produced 162,000 bpd less than allowed reaching a compliance 174%. Delayed maintenance works and lack of investment, partly due to the health crisis and partly because of the transition from fossil fuel to renewable energy, are to blame for these failures.

Any shortfall in oil supply can easily be made up by the group’s swing producers, namely Saudi Arabia, Russia, and possibly the UAE – after all these heavyweights have ample spare capacity at their disposal, logic says. According to the EIA, the OPEC+ group’s spare capacity stood at 6.9 mbpd at the end of July, which should decline as output is ramped up in the next few months. Investment firm Bison Interests, however, sees a different story. The spare capacity of Saudi Arabia and Russia is overstated and the quicker-than-anticipated growth on global oil demand could easily absorb the group’s excess capacity leading to structural deficit. The White Paper on the topic points out that whenever Saudi production reaches 10 mbpd the Kingdom’s onshore oil inventories start depleting implying actual spare capacity closer to 10 mbpd than to the stated 12 mbpd. The investment firm also emphasizes that Russian reference production of 11 mbpd, which is expected to go up to 11.5 mbpd from next May will simply be impossible to reach due to reduced exploration and capital investment after the 2014 oil price crash. It will be imperative to keep a close eye on the production levels of these two leaders of the oil cartel early next year. The perceived reversal of global stock depletion might never materialize if spare capacity constraints prove justified.