Brent recently hit $80 per barrel, which ushered in a flood of predictions for when we might hit $100 per barrel. But Saudi Arabia and Russia just crushed those dreams, with reports suggesting that the two top oil producers could move to allow higher levels of output at the upcoming meeting in Vienna on June 22.
Assuming they do indeed lift output levels, does that mean that the rally is over? Are we in for a sharper price correction? It’s possible. But it’s also possible the market is overreacting. Let me explain.
On the one hand, there is ample evidence that the oil price rally was sentiment driven. Brent prices have rallied nearly 90 percent since bottoming out at $45 per barrel nearly a year ago. The steady climb in prices occurred alongside a record buildup in net-long positioning by hedge funds and other money managers.
Of course, the underlying fundamentals indicate that the market tightened significantly, but record bullish positioning began to look overstretched earlier this year. In fact, some savvy investors started booking profits, selling out of their positions in April. Brent has edged up over the month of May, even as the speculative net-length in the ICE Brent futures market fell back significantly.
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In other words, the smart money was already starting to bet against higher oil prices even as geopolitical fears spread like wildfire over the past month. Speaking of which, much of the premium on oil in the past month has come as a result of geopolitics, not necessarily the underlying fundamentals. Brent added about $6 per barrel in the two weeks following Trump’s decision to pull out of the Iran nuclear deal.
However, fears of outages in Iran are a little premature. There is almost no chance the U.S. can knock of as much oil as it did before the JCPOA – about 1 million barrels per day (mb/d) – when it worked in concert with other global powers. The U.S. is now going it alone vis-à-vis confrontation with Iran, and while Washington still carries a lot of sway, the Trump administration won’t be able to disrupt as much oil. Estimates vary, but let’s say somewhere around 500,000 barrels per day. That is a large volume of oil knocked offline but it isn’t a game-changer. Fears of acute shortages are likely overblown.
Even as OPEC lines up a change to its current production cuts, there are reports that some cargoes in the Atlantic Basin are going unsold. Physical traders told Bloomberg in early May that some cargoes were looking for a home in northwest Europe, the Mediterranean, China and West Africa. The surplus has weighed on Brent timespreads, narrowing the July-August premium. The shrinking backwardation is a red flag for the oil market.
All of that is to say that there is plenty room for a price correction. Lopsided bets from hedge funds and other money managers have repeatedly ended badly, with a liquidation of positions sparking a selloff in oil prices as soon as sentiment turns bearish. Anybody involved in the oil market over the past three years would recognize the looming threat from the current overly bullish makeup in the futures market.
OPEC may have just provided the spark for just such a correction, with news reports suggesting that they could add as much as 800,000 bpd back into operation. No wonder Brent was off more than 3 percent during midday trading on Friday. The premium from the Iran nuclear deal – somewhere around $6 per barrel – could come off entirely, which suggests there could be some more room on the downside.
However, a market meltdown is unlikely, and even a strong price correction beyond the current selloff is not a given.
The amount of oil that OPEC could restore is manageable. After all, Venezuela is losing roughly 50,000 bpd each month, which means that it alone could wipe out the presumed increase in OPEC production by the second half of next year. Moreover, some see Venezuela losing 600,000 bpd by the end of 2018, a staggering sum.
On top of that, adding some supply and short-circuiting the rally will also protect demand growth this year, with most analysts pegging it at about 1.5 mb/d. Consumers have started to get a bit restless with higher prices at the pump, symbolized by President Trump’s tweet in April charging OPEC for making “artificially Very High!” Saudi Arabia is a close ally of Trump, and thus wants to keep him happy. But keeping oil prices from going too high too fast also ensures that demand will continue to grow at a brisk pace.
Inventories are already back to the five-year average, which means there is a good chance they dip below average in the second half of this year. That smaller cushion means that any outage, even a small one, could provide a jolt to prices. Higher OPEC production, perhaps as much as 800,000 bpd, could prevent such a deficit, but increases of that size are not a foregone conclusion.
Saudi Arabia still needs higher oil prices as it stags the IPO of Saudi Aramco, which oil minster Khalid al-Falih just said is slated for 2019. Crucially, he said that the timing will “depend on the readiness of the market, rather than the readiness of the company or the readiness of Saudi Arabia…We are ready, the company essentially has ticked all the boxes,” he said. “We’re simply waiting for a market readiness for the IPO."
What does that mean? Al-Falih is essentially saying oil prices are not high enough. He may want to keep Trump happy by slowing the gain in prices, but there is no way Saudi Arabia will launch an IPO of Aramco with Brent dipping down towards $60 or below.
The bottom line, then, is that the Saudis want to let some steam out of the market, but they have no interest in causing oil prices to crash again. Russia is reportedly the one that wants to increase the group’s output by 800,000 bpd, but Saudi Arabia wants it closer to 300,000 bpd.
That sets up the oil market for some serious volatility over the next few weeks. A price correction might be in order, but based on the 3.5 percent decline in prices on Friday, the market is already starting to price in a significant increase in OPEC/non-OPEC production for the second half of the year. If Saudi Arabia and Russia come up with something more modest – of around 300,000 bpd – it could catch a lot of oil traders off guard. And the bull run could be back on.