Monday, September 18, 2017

Are Oil Markets Finally Rebalancing?


I wrote the article “Are Oil Markets Finally Rebalancing?” as an email in response to Ms. Kamila Aliyeva’s interesting questions concerning the present state of the oil markets. Ms. Aliyeva, a business journalist, then introduced my emailed comments into her article “Expert: Gradual Decline in Oil Inventories Should Result in More Balanced Markets in 2018,” which was published by Azernews, an English-language Azerbaijani newspaper, first, on September 18, on its online edition and then, on September 22, in its paper edition.   


September 18, 2017

LONDON — On September 5, Russia and Saudi Arabia discussed in St. Petersburg, Russia, about the possibility of extending for a second time the oil output-cut deal between OPEC and non-OPEC producers negotiated in November 2016. This meeting on the Russian soil was one of the preparatory meetings that oil producers must conduct if they want to try to implement a unified strategy aiming at freezing oil production levels. In addition, considering Russia’s position as the world’s largest producer with almost 11 million bpd, thinking of an oil strategy confined to OPEC members alone would not be a recipe to success.

It is certain that at the end of next November, when there will OPEC’s 173rd ordinary meeting and another meeting including OPEC and non-OPEC members, the main topic will be what petroleum policy these countries want to implement after the expiration in March 2018 of the extension of the 1.8 million bpd output cut. This first extension was agreed on last May in Vienna by OPEC and 10 non-member countries—among them there was Russia. The real problem is that defining a working strategy suitable for all the involved oil-producing countries is always very difficult.

The common denominator among all these countries is their fiscal budget’s strong dependence on their oil revenues. But apart from this, these countries have different histories, which translate into different economic and political agendas. On top of this, the difficult cooperation among OPEC members is linked to the intense political struggle between Saudi Arabia and Iran for regional influence. Under the present deal, Iran obtained an exemption to slightly raise its output, which had been reduced by years of Western sanctions. In August, Iran pumped 3.82 million bpd of crude oil.

Until a few weeks ago, with still oversupplied oil markets, it seemed that a production freeze would be not very useful because OPEC production rose to 32.8 million bpd in July (highest value in 2017)—Nigeria, an OPEC member under exemption from output curbs, pumped more crude oil. In practice, the only valid solution was a consistent production cut, which indeed was politically very difficult to agree on.      

Now, according to the latest data from the International Energy Agency (I.E.A.), oil demand is increasing faster than previously thought. In practice, the I.E.A. states that oil demand will grow by 1.6 million bpd (or 1.7 percent) in 2017. This means that oil markets are in the process of rebalancing because finally inventories are decreasing. And, although in a feeble manner, markets are reentering a backwardation phase. In addition, in August OPEC production was 79,000 bpd less than July’s production.    

Now, the next two months and a half, which lead to OPEC’s November 30 meeting, will be crucial to understand what petroleum policy the oil-producing countries will apply after March 2018. In specific, if the present, and still in its infancy, rebalancing of the oil markets continues, it could really save oil producers from being forced to implement a production cut larger than the present one, which is worth 1.8 million bpd.

Considering the current possible sustained transition toward a backwardation phase, predicting where the oil prices will be in 2018 is very difficult. Commodity price movements depend on inventories (cyclical component linked to short-term supply and demand shocks) and marginal costs (structural component linked to the long-term impact of technology, geology, and politics).

When we look at 2018, we need primarily to consider the cyclical component, i.e., inventories. In this regard, the contango phase of the oil markets, which has been a constant phase since the second half of 2014 because of the crude oil oversupply, has begun to lose ground because there has been an increase in the demand for prompt-loading oil barrels and in the expectations that the oil markets will rebalance over the next year. All this means a drawdown in crude oil stocks, i.e., an inventory reduction.    

In specific, Brent’s futures curve has continued to flatten for several months and its back end is now in backwardation. Instead, despite consecutive weeks of inventory draws, W.T.I. remains in a light contango—but, indeed, there has been a relevant decrease in the contango level. The financialization of the price of crude oil is still not entirely clear, but it has an effect because calendar spreads are able to understand better the balance between supply and demand. In addition to this, if we give more importance to futures fundamentals than to physical fundamentals, it’s evident that these expectations will be then reflected in the spot price of a specific benchmark.

It’s evident that, under the current production levels, the gradual decline in global crude oil inventories should be able to produce more balanced oil markets in 2018, which could help maintain the current price levels, if not to produce a slight price increase as well. But, much depends on what oil producers will decide next November. If they prolong their crude-oil production-cut agreement, this scenario could materialize. Instead, if they look at their long-term interest (expand their market share at the expense of the U.S. shale producers) and return to maximum production, oil markets would probably go to square one, which in this case means an oversupply of crude oil.

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