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Edward Bell - Commodity Analyst
Published Date: 08 March 2020
OPEC+ failed to reach an agreement on deeper production cuts at its extraordinary meeting at the end of last week and members look now to be preparing for a price war by announcing plans to actually increase output. The outcome is an astonishing reversal of what appeared to be a pending production cut to compensate for the decline in demand caused by the Covid19 (coronavirus) outbreak. Oil prices responded violently to the break-up of OPEC+: Brent futures closed down 9.4% on the day at USD 45.27/b while WTI collapsed by more than 10% to settle at USD 41.28/b. Here we outline some of the immediate implications of the end of OPEC+ production.
Russia’s energy minister, Alexander Novak, said in leaving the OPEC+ meeting that from April 1st producers would start “to work without minding the quotas or reductions”, implying that Russia will be moving to increase production quickly. Likewise, Saudi Arabia has announced enormous discounts on its official selling prices for April which likely presages an increase in production. For reference, the OPEC+ cuts that are in place until the end of March are meant to take more than 2m b/d out of the market. That scale of outage hasn’t materialized given varying degrees of compliance but should OPEC+ members choose to raise output from Q2 onward, a wave of oil will be unleashed onto markets.
We expect to see Saudi Arabia, the UAE and other large producers in OPEC increase production over the rest of 2020 as they return to a market-share strategy rather than price targeting. For the major economies in the MENA region, current production levels are around 2m b/d below their peak levels since 2018. There is thus ample headroom to increase output from the region while there is another 350k b/d from non-MENA OPEC members. Russia is producing at around 130k b/d below peak levels and the country appears to be explicitly implementing a market-share strategy.
Going after market share does have a track record of working in terms of rebalancing markets. In 2015 when OPEC moved to raise production to take on the emergence of US shale production, total output from the US did fall. However, as OPEC+ adopted a strategy of trying to secure prices they helped to effectively provide a subsidy to the enormous growth in US oil production.
Source: Bloomberg, Emirates NBD Research. Note: production relative to Jan 2015 levels.
With demand negatively impacted by Covid19 much of the increase in production will invariably find its way into inventories. As OPEC+ implements a market-share strategy we expect headline market balances to remain stuck in surplus in for the first three quarters of the year. A tentative deficit should emerge in Q4 as non-OPEC suppliers react to price volatility by limiting production. But while the headline balance numbers shows an—eventually—positive trajectory, the lost consumption will mean inventories blow back out above 3bn bbl in OECD stocks and push the days of demand to nearly 69 days in Q2, a level with no precedents.
Source: IEA, Emirates NBD Research.
Outside of the OECD, inventories are already showing an upward trend. Product stocks in Singapore have risen considerably since the start of the year and may widen further as China unloads excess products onto international markets. The build in stocks, along with a drop in consumption, is weighing on refining margins with cracks for Singapore jet over Dubai crude sinking to multi-year lows.
Source: Bloomberg, Emirates NBD Research.
The consequence of markets now having to contend with a demand shock, supply deluge and bursting inventories will inevitably be felt in prices. Indeed the enormous daily decline in the wake of the OPEC+ meeting may just be a sign of things to come. An inventory blow-out in Q2 could lead to prices declining by more than 50% y/y for average Brent that quarter (implying USD 33/b on average) and struggling to improve considerably thereafter. The market-share strategy bears considerable risk for OPEC producers as fiscal positions would deteriorate and balance of payments crises—and questions about the sustainability of monetary policy—re-emerge.
Markets are clearly positioning for more downside risks ahead. Put premiums for Brent options have surged to their widest levels in the last five year under a 25D risk reversal strategy while short positioning continues to be established. In the week ahead of the OPEC+ meeting new short positions in both Brent and WTI took speculative net length to just 7% of open interest in the Brent market and 3% of the WTI market. As the contango in the forward structure for both markets entrenches (see charts below) we are likely to see more long positions closed out, particularly in Brent where there is more room on the downside.
Our price assumptions for Q1 2020 look largely on target: Brent average USD 58/b vs USD 58.89/b ytd and WTI at USD 55/b vs 53.50/b ytd. In light of the expected surge in OPEC+ production and overwhelmed market balances, we are revising our oil price assumptions for the rest of the year. We now expect Brent prices to average USD 45/b and WTI at USD 40/b with troughs in Q2 before a tentative recovery over the rest of the year.
Source: Bloomberg, Emirates NBD Research.
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