The oil market’s knee-jerk reaction to Russia’s announcement that the OPEC/Non-OPEC cooperation deal would be reviewed in June was more instructive of the market’s insecurities and a lingering neurosis that oil producers would once again pull the rug out from underneath them (and discover there is no floor) than any actual potential for this agreement to get derailed. And judging by the price action since the meeting, it appears that many bought the Russian resistance ‘narrative’ hook, line and sinker.
The hysteria whipped up in the days and weeks leading up to the OPEC meeting in fact was in stark contrast to the consistent comments out of both countries. But just in case there was any lingering doubt, Saudi and Russian officials could not have been clearer about their commitment to cooperating and reducing inventories in the lead up to the meeting. Yet the market remained highly sceptical. This episode underscores to us just how much the market is struggling to let go of this narrative that Saudi Arabia wants lower oil prices and more market share. Nothing could be further from the truth (for more details, please see our E-mail alert: OPEC decisively commits to bringing down inventories, 30 November 2017).
The events in Vienna should have (again) solidified and confirmed the new strategic relationship between Saudi Arabia and Russia and its implications for oil policy. Both countries remain firmly committed to managing supply until inventories fall to the five-year average. Russia and Saudi Arabia are 100% aligned on the need to continue to manage the market for most of 2018, even if a conversation needs to begin over when and how to begin rolling back supply curbs. Russian officials were clear that just as production cuts were gradual and coordinated, so too will production hikes when they become necessary. Given how much Saudi Arabia has cut this year, and given its persistent public pronouncements on its commitment to bringing inventories down, it’s not clear what more can be said or done to prove to the market that there will be no cataclysmic unwind of this agreement that leads to a flooding of the oil market and a repeat of the massive stocking cycle that took place in 2015 and 2016.
Tops and Bottoms
While the market continues to fret and worry about the downside, both Russia and Saudi Arabia have shifted their focus on upside to price. Many delegates are beginning to look at $60 per barrel Brent as a potential floor for oil prices. OPEC action in the past year and a half shows it is proactive when oil prices are below $60. This will continue to be the case. The question now is if it will remain proactive with oil prices over $60. Khalid al-Falih’s comments this week affirmed that the Kingdom will remain proactive in 2018 and that it will intervene more aggressively if inventories build again. So $60 should not be thought of as a trigger, but rather a guide—should Brent prices fall below $60 Saudi policy will be proactive.
Russia is also focused on oil upside, though for very different reasons. Russian oil companies, because of the country’s tax structure, do not stand to gain from oil prices over $50 per barrel, and thus have little incentive to support higher oil prices. There is a similar trend at play for the central government, as while higher oil prices will mean more tax revenue, they will also lead to currency appreciation stemming from increased earnings, which then have to be converted into roubles (the central bank has been actively intervening this year to try and counter an appreciating rouble). These are clearly complicated dynamics and can’t be oversimplified into specific price ranges and targets. But Russia’s sensitivity to prices going much higher, and OPEC’s preference for a floor at $60, leaves a key question begging for answer—what is the ceiling? If it’s $70, this then becomes a rather narrow floor-to-ceiling range in which to try to navigate prices. As one delegate in Vienna noted to us, it would be ideal if the price floor could be $60 Brent and the ceiling at $60 WTI. Clearly one man’s floor is another man’s ceiling.
Brent crude oil has been trading roughly in range of $40-$60 per barrel since early 2015, with the exception of a brief spike above in early 2015 and brief spike below in 2016. With inventories now falling materially and given expectations for continued drawdowns in 2018, depending on many variables, it is reasonable to expect oil prices to shift into a new higher range. While OPEC officials have not articulated a desire for a new range for oil prices, their actions certainly point to Brent prices shifting to something higher. If there was any doubt over whether Saudi Arabia would cut further to bring down inventories, those doubts should have been put to rest. Saudi Arabia is all in.
Oil markets this week experienced a taper tantrum of their own when OPEC and Russia hinted there may be an endpoint to this deal. But the only reason to consider an exit strategy is because the end is in sight. Moreover, once OPEC and Russia take their foot off the brakes, this will signal they are uncomfortable with prices rising further. But just as the Fed was ahead of the bond market in 2013 in recognising that the post-financial crisis trauma had begun to ebb and the economy was on a better footing requiring less intervention, OPEC also is ahead of the wider oil market in seeing a more balanced market than the consensus appreciates. OPEC is clearly preparing for when it will begin to unwind its own extraordinary measures as the market glides back into balance.
Brent: Dated Brent and timespreads have been bid up over the course of the week in part due to strong local demand as European refiners return from maintenance. The strength in Brent is all the more remarkable given the strength in Brent-Dubai. Ultimately, strong refinery margins continue to drive demand for local barrels in Europe. Despite 1.5 mb/d of US crude exports, Med and WAF diffs are starting perk up as refiners try to secure incremental barrels. Demand remains very strong.
WTI: TransCanada’s 0.58 mb/d Keystone pipeline resumed commercial service this week sooner than expected on a 20% pressure restriction. WTI spreads sold off aggressively on the news. Aside from the daily spread gyrations, the Keystone outage is fundamentally bullish for prompt US crude balances given the outage has already resulted in some 7.54 mb of lost crude from the Midcontinent. And it will continue to tighten these balances as the pressure restriction caps Canadian pipeline outflows. Meanwhile, Saudi imports bounced off their lows for the year as maintenance at the Abqaiq field in September shifted some flows to the USGC and cuts were concentrated in Asia, which is home to the Kingdom’s Arab Extra Light crude customers. Saudi imports, however, remain well below normal levels. For more details please see our Data Review: US Department of Energy, 29 November 2017.
|Fig 1: WTI-Brent spread, $/b||Fig 2: Brent CFDs, $/b|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Gasoline: US gasoline inventories rose again this week, pushing stocks back above the five-year average. Flows from Europe to Asia and an expected uptick in Middle Eastern and WAF buying should cap imports into the USEC, though the domestic arbitrage between the USGC and PADD 1 remains workable. Alongside seasonally weaker demand, USEC stocks should continue to rise. Though prompt spreads have been weakening materially since the Harvey-induced spikes in the fall, summer spreads have started to rally. In fact, summer spreads are significantly higher than this time last year and are tracking 2012’s very strong levels. This could reflect the very strong refinery maintenance expected in H1 18.
Distillates: US distillate stocks rose broadly in line with the seasonal average w/w increase, though PADD 1 stocks fell by 0.2 mb w/w, likely supported by improving heating demand in the region—oil-weighted HDDs in PADD 1B were slightly above normal over the first four weeks of November. However, with several cargoes pointed toward the USEC and the arb between the USGC and USEC remaining workable for now, the market should be well supplied in the coming weeks.
|Fig 3: Jun-Jul RBOB spread, c/g||Fig 4: Mar-Apr HO spread, c/g|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|