From the Economist's Chair: A Fourth Bridge for Opec+

Author David Fyfe, Argus Chief Economist

The Forth Bridge in Scotland was opened on the 4th of March 1890. Opec+ Ministers will hope their meeting on the same date 131 years later provides a bridge to both stronger oil demand and sustainably higher prices.

Transcript

Judging by the financial press these last two weeks, producers may head into Thursday’s Ministerial meeting with more optimism than for some time. With Opec+ having tapered production increases originally due from January, and Saudi Arabia steepening its own cuts by an additional 1 mb/d in February and March, most observers now expect production increases of between 1.5 and 2 mb/d starting in April. With crude back above $60 and increased talk of an imminent commodity super-cycle, measured production increases seem to be already baked-in to current prices.

Under the terms of last April’s unprecedented production deal, Opec+ is committed to produce nearly 6 mb/d below late-2019 levels for the next 12 months, before then deciding whether to extend or end the deal. In reality, ongoing geopolitical and demand-side uncertainties may require yet more market micro-management in the intervening period.

In the group’s favour, external supply threats for now seem less pressing. Guidance from Permian Basin producers suggests largely flat 2021 output. Operators insist that upstream capex will not be ramped up in response to higher crude prices in the short term and that surplus revenues will instead be diverted towards paying off debt or returned to shareholders. Higher demand and normalised inventories on a sustained basis would be required before major increases in US capex are sanctioned. So the risk of a major 2021 supply overhang from outside Opec+ looks limited.

Those of a bullish disposition make the reasonable observation that higher prompt prices and steepening backwardation don’t lie. Demand, so the argument goes, must be stronger than recent lagged monthly data suggest, implying that a rebalancing of global oil stocks could potentially occur before the end of 2021.

Further fuel to the bullish commodity story comes from financial and derivatives markets. Speculative net length in crude is back near record highs, and the safe-haven appeal of gold and US Treasuries is dwindling. The USD is also likely to weaken further in 2021, even if it has for now stabilised after rapid declines in November and December. An imminent financial rescue package is already in front of the US Senate. Although the original $1.9 trillion price tag may be trimmed for political expediency, nonetheless bond markets are pricing-in sharply higher inflation expectations, which in turn are pushing investment dollars back towards commodities, widely perceived as an inflation hedge.

However, despite this bullish cross-commodity start to the year, uncertainties on the demand side of the equation remain considerable. Expectations for incremental global oil demand between now and end-year sit in a +2.5 to +6.5 mb/d range. And forecasts for 2022’s annual demand growth are similarly dispersed at between +2 and +4 mb/d. The crude market pivots on relatively narrow shifts in fundamentals, and 1-2% changes in demand or supply can cause major swings in spot crude prices.

Herein lies the quandary for Opec+ Ministers: if they re-instate shuttered production too quickly and demand recovery again falters (as threatened by the recent stalling of Covid-19 case reductions) then they risk choking-off the stock draws that have so far drained nearly half of the surplus accumulated in early-2020. Moreover, production restraint would have to be extended beyond the planned April 2022 endpoint, all the more so if Iranian exports are again rising by then. Amid signs that Russia and central Asian producers, among others, are losing their appetite for continued supply restraint, stitching together another deal amid rising Iranian volumes could indeed be problematic.

But if, in contrast, demand is at the higher end of the range of expectations, then the market can easily absorb all that Opec+ can throw at it, and arguably needs an additional 1-to-2 mb/d of re-instated Iranian exports in 2022.

Demand uncertainty aside, there are questions too on the geopolitical front. Normally, Opec+ decision-making is insulated from the vagaries of international diplomacy. But so fundamental are the changes being wrought by the incoming US Biden Administration that historical precedent may be losing its predictive power. On the one hand, Biden’s domestic energy and climate agenda will further restrain shale expansion over time. This potentially undermines the arguments of Russia and others that Opec+ needs to quickly regain market share before US supply rebounds. However, the political dynamic between Washington, Riyadh and Tehran is also shifting significantly. Saudi Arabia and Iran have traditionally put political rivalries to one side when assessing oil production policy. Nonetheless, a scenario in which Washington rapidly re-engages with Iran, while at the same time distancing itself from Crown Prince Mohammed bin Salman, might see Riyadh pre-empt resurgent Iranian exports with extra barrels of their own.

Neither oil demand uncertainty, nor these multiple geopolitical conundrums, will be resolved quickly. So, while we should expect increased Opec+ production from April, that won’t necessarily be “job-done” for the ensuing 12 months. Don’t be at all surprised if monthly or bimonthly Opec+ Ministerial gatherings persist for a while longer.

That’s all for this edition of “From the Economist’s Chair”, so thank you for listening.

Don’t miss much more on the commodity markets to be found at www.argusmedia.com

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