Oil drifts lower amid uncertain supply outlook

Oil markets remain under a veil of uncertainty following the failure of OPEC+ to reach agreement on the next phase of its production cut agreement. Since the start of the month oil prices have drifted lower amid no apparent shifting of positions either from the UAE or the rest of OPEC+ led by Saudi Arabia. Markets are seemingly pricing in an erosion of OPEC+ integrity for August onward, with producers likely to increase output if they can.

Amid this apparent vacuum of official OPEC+ policy, this week markets will focus on reports from the IEA and the OPEC secretariat. Both are likely to highlight a widening supply shortage in H2, premised on an assumption that no additional OPEC+ supply will enter the market. We had been projecting a deficit in H2 2021 of around 1.2-1.5m b/d but that was on the assumption that OPEC+ would gradually phase back in some of its restrained output. Were OPEC+ to keep its output levels from the end of July unchanged, that would widen out our deficit projections and risk adding considerable upside to prices.

However, no agreement risks provoking the ire of nearly all other economies, particularly the US, China and India and will come at a time when financial markets are already anxious about the potential for inflation to rip higher. This lack of agreement would leave all market participants unsatisfied and would likely need to resolve in one of two ways:

• One, a behind-the-scenes deal where issues around its baseline level are addressed and all countries are allocated a notionally higher baseline, which allows them to increase output. We would still expect that the production increase would leave oil markets undersupplied but it would help to provide a signal that OPEC+ is responsive to the improvement in demand and short inventory levels. Prices would likely temper some of their gains and moderate closer to the USD 70-75/b range. We believe this is the most likely scenario at present.
• Second, the UAE could determine that remaining bound by the OPEC+ restrictions is no longer in its economic interests and increases production unilaterally at a level it feels is appropriate given the investments it has made in upstream capacity. We would expect other OPEC+ producers to follow suit and increase output if they have flexibility to do so. Prices would risk considerable downside in that scenario although the amount of ‘free’ spare capacity is likely more limited than market estimates have in place. Prices would likely push below USD 70/b and probably hover in a USD 60-75/b range, although we wouldn’t rule out potential dips lower.

Also of note from the IEA and OPEC will be their assessment on the response of non-OPEC+ producers to currently high prices. US oil production has been steady for much of the past year, barring momentary dips related to weather shocks, even as WTI prices have pushed substantially higher. At around 11.3m b/d, US oil production is 1.8m b/d below its peak level in February 2020 even as the drilling rig count has recovered considerably from the trough level it hit in August 2020.

While oil prices are high now, expectation that this could be as good as it gets for a few years may be feeding into producers’ reluctance to deploy rigs. A survey from the Kansas City Federal Reserve estimated that producers needed around USD 72/b to allow for a substantial increase in production. Price expectations among producers for five years forward only creep up to USD 78/b, suggesting that even in nominal terms producers don’t see enormous upside from prices at their current levels.

We expect to see a resolution to the OPEC+ disagreement that would allow some oil back into the market. But with inventories having drawn considerably and no material response yet from non-OPEC+ producers to high prices and rising demand, we maintain our expectation for prices to be supported at an average of USD 70/b in Brent for the rest of the year.