OPEC and allies to keep oil market hot

OPEC+ decided to keep its production targets largely unchanged at the 14th ministerial meeting of the producers’ bloc held in early March. The levels for March will be rolled over for an additional month with modest increases for Russia (130k b/d) and Kazakhstan (20k b/d) permitted while Saudi Arabia will keep its additional 1m b/d of cuts in place for an additional month. The next ministerial meeting will occur at the start of April.

The immediate impact of the rollover, which surprised market observers including us, is to keep oil markets overheating. Front month Brent futures have rallied nearly 34% since the start of the year and are only a short distance away from USD 70/b. Market structures also remain tight: 1-2 month time spreads in Brent closed the week at USD 0.68/b, around the 87th percentile for the spread in data going back to 1990.

Oil has rallied sharply since the start of 2021

Source: Bloomberg, Emirates NBD Research

While the rollover at this stage only applies for April and output levels for the rest of Q2 will be decided from the start of April onward, OPEC+ does now appear to be intentionally targeting oil prices moving higher. We would expect then for production to continue to be restrained even if prices pushed considerably higher and now expect a market deficit in Q2 (compared with a small surplus previously). Our outlook for H2 2021 already incorporated a deficit as demand recovers from the economic damage of the Covid-19 pandemic but now we see the risk of a considerably wider deficit emerging.

We are revising our oil price assumptions for 2021 considerably. We now expect Brent prices at an average of USD 67.50/b with an average of USD 70/b for Q2 onward. For WTI we now expect an average of USD 63/b with prices at an average of USD 65/b from Q2 until the end of the year. However, given that OPEC+ is now deliberately choosing surprise as an active market management tool we believe there is enormous risk to oil prices this year and that volatility will be elevated. A disorderly rise to USD 80/b or above based on excessive supply constraint seems just as likely to us as a collapse to USD 40/b if demand craters or there is a rapid non-OPEC+ supply response. We also do not see price gains this year as the start of a new super cycle in oil prices given the long-term outlook for oil demand to plateau amid new energy alternatives and ample availability of alternative supplies.

Emirates NBD Research oil price assumptions

Source: Bloomberg, Emirates NBD Research. Note: average of quarter.

For the post 2021 period we expect to see a positive supply response from producers outside of OPEC+. The WTI futures strip for 2022 is currently trading a little under USD 60/b, considerably above wellhead breakeven estimates for all major shale basins in the US. Even if there is a focus among US producers on dividends and output discipline this year, as Saudi energy minister Prince Abdulaziz bin Salman said he believed in post-meeting commentary, pricing conditions are attractive. Exploration and production companies have already responded to improving demand and price signals with the drilling rig count consistently pulling upward from a mid-2020 trough. A sustained WTI price at USD 60/b or so will support capex plans across non-OPEC+ producers.

Ample headroom in the US shale patch

Source: Bloomberg, Emirates NBD Research

Even within OPEC+ the higher prices may cause compliance with the production cut agreement to fray. In previous occurrences of rapid oil price gains OPEC production compliance has deteriorated as members seek to take advantage of higher prices. However, during most of those periods the cuts in production were nowhere near as deep as they are now: in the aftermath of the global financial crisis OPEC aimed to hold output at around 80-85% of total capacity before output trickled higher. At that time, sanctions on Iran and unrest in Libya and elsewhere helped to keep oil prices stable at around USD 100/b. Now there is even more space for OPEC and allies to add output back to the market: in OPEC, total production is currently at just 75% of capacity even when stripping out Iran and Venezuela whose ability to export are affected by sanctions (see Oil at 100: No, March 2021).

OPEC+, led by Saudi Arabia, also now appears to be purposely using surprise as an economic policy tool. The initial terms of the OPEC+ deal agreed last April laid out a schedule for the length of the deal and dates when output would be increased in line with improvements in demand, a kind of oil market forward guidance to borrow jargon from central bankers. OPEC+ has now discarded that stability-oriented approach in favour of responding to short-term price signals. For a group that controls roughly 50% of global oil supply, surprise policy entrenches volatility and erodes claims of acting in the interest of market stability. Most OPEC+ economies will undoubtedly receive a boost to their fiscal and external positions via higher oil prices in the near term. However, if fiscal largesse follows (either in the form of higher infrastructure or current expenditure), it will push against the reform drive many of these economies have undertaken in the last few years and keep the health of government finances, and the underpinning economies, linked linearly to the ups and downs in oil prices.