This is the first part of a three-part series on headwinds facing the crude market.
These have been interesting times in the crude market. Prices had been trading comfortably above $50/b since late March, with bulls re-trenching on the idea that Saudi-led OPEC supply cut will soon tighten balances.
And while today’s price declines could prove temporary, a measure of caution is advised to all bulls, for two key reasons — reasons that we’ve been watching closely since November.
First, the expectation that the OPEC supply cuts will tighten global crude supply is overdone. While there is likely a limit to how many OPEC barrels US shale can replace, anyone who thinks the godfathers of the shale revolution are going to sit idly by as prices soar probably wrote a book on peak oil.
Second, global refined product stocks are ample and will have to clear — with a noticeable increase in crack spread and differentials — before forecast demand growth can meet expectations.
The bulls say given enough time, OPEC-led supply cuts will drive prices higher. A recent S&P Global Platts survey pegged OPEC compliance on stated cuts at around 115% over January to March. That is truly incredible, and clearly part of any bull’s fundamental calculus.
But if cuts are actually taking place, what effect are they actually having?
The market’s ability to flood Asia and Europe with crude has become entirely unshackled. How long will it be before cut OPEC and Russia volumes are replaced by barrels out of Latin America, the US, Canada, North Sea and West Africa? And isn’t that already happening? Is this not the new normal?
US exports — and barrels from the North Sea and elsewhere — are indeed displacing the efficacy of the OPEC cuts. And the degree to which this is sustainable is key to determining when the market will balance.
For example, when a North Sea Forties cargo gets booked on a VLCC to South Korea or China, it is true that refiner demand in that Asian market is likely stronger than demand in Northwest Europe.
But this ignores a key aspect: The relative weakness of the Forties barrel versus the relative strength of a Saudi, UAE or Russian barrel is what makes the arbitrage workable.
The Forties barrel can be sent to Asia because of its weakness relative to the degree the Atlantic Basin remains glutted. Oversupply drives the contango needed for a trading company to stockpile a tanker’s worth of crude until it decides the time is right to send it east. Yes, a Northwest European refiner can step in and bid the crude up when necessary. But when that wanes, Forties heads east.
And it will continue to head east as long as the Brent/Dubai Exchange of Futures for Swaps remains narrow. And this will continue to hold as long as freight remains cheap and some Middle East producers continue to cut supplies, which will continue to support Dubai.
So here it is instructive to stipulate that OPEC cuts are having an impact, just not the intended result.
This is the essence of the new normal: the degree to which OPEC can manage at least some cuts is running up against the reality of non-OPEC barrels being produced to replace them.
And even if the cuts are established as effective, how long are they expected to last? For the cuts to be extended for any period of time, Saudi Arabia, Iran, Iraq and Russia must continue to get along.
The last 150 years or so of political science tells us that a nation-state will always do what is in its best interest. In this case, that’s churn out the most oil it can as soon as it can. Not unlike what US producers are doing.
The idea that a supranational body such as OPEC has the power to dictate the behavior of states — and sustainably constrict their oil production — is, and always has been, fraught with risk at best.
Yes, OPEC is able to manage a tighter market, for a while at least, as it did in 2008. But that simply led to unsustainably higher prices and, obviously, the rise of both the oil sands and US shale.
In Part 2, we discuss who is so bullish and why.
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