Oil’s Remarkable Price Run Is Just Beginning
As far as crude prices go, the oil market has overcome the pandemic. Brent traded above $67 per barrel last week, roughly $10 higher than it fetched a year ago when pandemic jitters started impacting oil prices and roughly equal the price at the start of 2020.
Some traders fear the market is running ahead of itself since financial players have had a significant influence in the rally by buying up oil futures contracts. But physical prices and the time spreads on the exchanges back up the strength of this market.
The forward curves for Brent and the U.S. benchmark West Texas Intermediate (WTI) are firmly in steep backwardation for the foreseeable future. That means prices for prompt oil deliveries trade at a premium to oil for later delivery and indicates a tight crude market. The oil market is done rebalancing supply and demand from the pandemic.
Supply cuts from the OPEC-plus alliance are responsible for balancing the market. Capital investment cuts by U.S. producers have helped, too. During recent fourth-quarter earnings calls, shale producers almost uniformly said they would not chase growth this year despite WTI’s recent spike to over $60 a barrel – the first time it has breached that level since early 2020. The shale sector’s commitment to capital discipline and delivering financial returns lifts a huge weight off of the back of OPEC. Shale isn’t a threat in the near-term, and the members of the OPEC cartel know it.
Also boosting the market is the prospect that 200,000 barrels a day or more of U.S. production frozen by Winter Storm Uri in February may never return, regardless of prices. Operators don’t consider investing in restoring this higher-cost output a good bet.
What to expect from U.S. production this year? It appears likely to rise from around 11 million barrels a day at the start of 2021 to exit at 11.6 million barrels a day at best, and average 11.3 million barrels a day for the full year. OPEC can handle that, particularly considering U.S. output was running at a peak 13 million barrels per day before the pandemic and registering annual growth rates of 1 million barrels a day. Shale is now under control.
The elephant in the room remains how the OPEC-plus alliance handles the 9 million barrels a day – including Iran – of spare capacity that it has sidelined. These cuts and hopes that Covid vaccines will boost oil demand sharply in the second half of 2021 are the main reasons for the recent rally in oil prices.
Saudi Arabia has led the way, including taking on an additional 1 million barrels a day cut in February and March to account for lost demand from fresh Covid outbreaks and lockdowns, particularly in Europe.
Riyadh doesn’t plan to extend this bonus cut past the end of March. Saudi is eager to regain the market share from these cuts, particularly in Asia, where China has restored its crude demand to pre-pandemic levels.
The price surge is the perfect pretext for OPEC-plus to decide at its meeting this week to bring more than 2 million barrels a day back to the market. They need the revenue – and prices are too high to let this opportunity slip by. Saudi Arabia will account for most of the additional barrels that reach the market since it has made the biggest cuts.
Managing the supply increase to meet recovering demand is the defining challenge facing the OPEC-plus alliance. The good news is that many experts expect demand to return to close to pre-pandemic levels by the end of this year.
With many metrics now pointing to an undersupplied oil market, OPEC+ finds itself in a relatively enviable position. Besides the rosier demand forecasts, Libya’s export recovery looks to have paused and the prospect of Iranian crude supplies flooding the market post former US President Donald Trump is receding.
But signs of fraying OPEC-plus compliance at the margins could become more prevalent, and resistance to continued production restraints reflect the persistence of fault lines that briefly broke up the alliance last year.
Russia, Iraq, Nigeria and Kazakhstan are eager to ramp up production. But prices of $65 are enough to tempt any in the 23-member alliance to produce more than its quota. Russia, for instance, does not want to see prices near $80 and believes a range between $45 and $60 is optimal to mitigate volatility.
Still, the market believes the Saudi-Russian-led OPEC-plus alliance has the situation under control. The bulls are firmly in the driver’s seat at the moment.
Goldman Sachs GS +3.3% just raised its Brent forecast for the third-quarter of 2021 to $75, and key consumer countries like India are starting to express concerns about rising prices.
While balance has returned to crude markets, the same cannot be said for refined products – although they are starting to turn the corner, too. Price differentials are moving toward pre-pandemic levels and flat forward curves show product inventories are draining. There is no tightness but no oversupply either.
It took the crude market four months from the first signs of tightness – from mid-October to mid-February – to show its full strength. That might be an ambitious template for refined products, which have already seen eight straight months of inventory draws and still have some 400 million barrels more in tanks than their pre-pandemic levels.
Rebalancing crude supplies was an easier task than refined products. The crude market has the disciplined Opec-plus alliance holding back supply. There is no equivalent among global refiners.
The product market received a jolt from Winter Storm Uri. It pushed product stocks down by 20 million barrels below pandemic levels. The U.S. market has rebalanced all it can. Europe still has a surplus – mostly diesel – while the big product surplus, built on cheap crude purchased last year, is in Asia. This allows for a slow and steady drain – but it prevents refiners from increasing runs and crude producers from opening the taps. And at the end of the day, crude prices derive their strength from physical demand from refiners.
At 95 million barrels per day, consumer demand for refined products in the first quarter of 2021 is still down some 5 million barrels a day from its previous year level during the same period. And consumption still faces headwinds with the resurgence of the pandemic.
But vaccinations are showing encouraging results, more stimulus is on the way, and most demand forecasts for the second half of the year are on the upswing. At the end of 2021, demand may only be 2 million barrels a day below its end of 2019 level, which is impressive considering where things stood last spring.
Oil prices may take an occasional breather from here on out, but the general trend is upwards unless OPEC-plus management completely unravels.
Demand will improve while investments in upstream projects have been sagging since 2015 and took a 30 percent dive in 2020. Oil company budgets point to another decline in upstream spending this year, which means the new supply outlook is weak.
The possibility of a supply crunch arriving before the end of 2022, spiking prices above $100 a barrel once again, looks more realistic every day.
The U.S. shale sector is flatlining and more and more international oil companies are shifting toward renewable energy projects and away from traditional oil investments – while demand appears to be ready to come roaring back to pre-pandemic levels.