This one goes to 11

Published at 12:06 29 Jun 2018 by . Last edited 11:18 22 Aug 2019.

Oil prices have rebounded sharply since the OPEC meeting one week ago, in part due to inconsistent Saudi signals about whether the surge in production from the Kingdom will be effective immediately. Since Saudi Energy minister Khalid al-Falih said in Vienna that OPEC+ will be increasing its production by 1 mb/d in order to tackle overcompliance (and since the meeting, even higher numbers have been talked about), WTI has now rallied by roughly 12% since the OPEC meeting, and Brent by 7.5%.

The admission by the US State Department during a briefing that it plans to sanction anyone who continues to lift Iranian crude after 4 November and wants to cut Iranian exports to zero has helped explain the behaviour of the Saudi delegation in Vienna last week—the Saudis were clearly trying to push for higher OPEC volumes (and by extension lower prices) in anticipation of this move by the US. As the Saudis kept floating possible production increases (first 0.3 mb/d, then 0.6 mb/d, then 0.77 mb/d, and finally 1 mb/d), the market grew more and more sceptical. In a nutshell, the market is completely unnerved by the inconsistency and desperation in the Saudi position.

There is no other way to describe Saudi actions over the past 10 days other than to say that this bordered on unmitigated panic. The narrative kept changing daily, and listening to the Saudis talk about their July oil production and exports was a bit like hearing a cattle auctioneer shouting out the latest bid. With leaks to the press that July production levels would rise first indicating 10.3 mb/d, then 10.6 mb/d and finally 11 mb/d was an act of clear desperation (this is spinal tap). The problem is that the market was never convinced. Our soundings suggest the Saudis are actually having problems placing their barrels into the market as the prompt physical is very oversupplied (with Iranian exports yet to fall off steeply), especially given the grades they are offering, and so production will end up closer to 10.6 mb/d in July. At the moment, with the market well supplied, the Saudi surge in production has much more to do with optics and politics than fundamentals.

Fig1: Saudi production, mb/d Fig 2: WTI and Brent net change, $/b
Source: Various media outlets, Energy Aspects Source: Bloomberg, Energy Aspects

Denial, its more than a river in Africa
The State Department’s Iran ‘bombshell’ clearly caught the market unprepared, and flat price has had to adjust. The market, and indeed even the buyers of Iranian crude themselves, had expected that the Trump administration would allow them time to reduce their oil imports over a much longer period, by issuing sanctions waivers to nations that made significant efforts to cut their purchases. That expectation was partly based on previous comments from top Trump officials, as well as the Obama administration’s previous effort to wean the world off Iranian oil over several years. Thus, most people now have to adjust their balances by increasing the general consensus of only a 0.5 mb/d reduction in Iran exports in Q4 18, to something closer to 1.5 mb/d (for more details please see our E-mail alert: Record Saudi output cannot offset US efforts to eliminate Iranian exports, 26 June 2018).

There has been a great deal of denial with regards to Iran. Even when Trump announced the re-imposition of sanctions on Iran, many continued to believe that the loss of exports would be minimal, with some suggesting that because China and India are impervious to US sanctions, the impact could be as low as 0.2-0.3 mb/d. But, EU efforts to insulate European companies have failed, and these businesses have already started to halt their purchases of Iranian crude. Even the Indian oil minister has asked its refiners to prepare for a ‘drastic reduction or zero imports’ scenario from November. We believe this is a message to the refiners to start looking for alternatives in case the Indian government is unable to negotiate waivers, rather than actually implying Indian imports will fall to zero, but this is still a significant development given prevailing expectations. With regards to China, while the official position is that it will not abide by the sanctions, the companies say they will await greater clarity on US tariffs by 6 July before making any decisions on Iranian volumes. Namely, we understand that if the US chooses to push the tariff agenda, then China should continue to take Iran barrels. However if the US is a bit more conciliatory and offers compromises, then its very possible China would be willing to reduce Iran imports. In either case, it is technically impossible for China to take all the incremental crude backed out by other countries in its existing refineries.

And while some are asking if the Iranians would be willing to come to the negotiating table given the looming financial impacts, that assumes there is even a table for them to come to. It is important to remember that for the Trump administration this has always been about more than the nuclear programme. This is about the Iranian regime and its actions across the region among a host of other issues. An Iranian capitulation would not just involve giving up its nuclear programme. It would effectively mean the end of the regime. For Iran’s leaders, the survival of the Islamic Republic is the goal. We find it implausible that the Iranian regime will capitulate.

Thus, the market has had to reprice for the fact that balances are going to be materially tighter in Q4 18, at the same time as spare capacity as a percentage of total demand is going to be below 1%. And perhaps most worrying is that we have not even potentially seen the worst of the supply outages, given the risks to production in Venezuela, Libya (see E-mail alert: Closure of eastern terminals could take Libya's production down to 0.35-0.40 mb/d in the next few days, 28 June 2018) and Nigeria. Thus, the risks to price are much more heavily skewed to the upside than the downside given the balance of risks to supply, the elimination of global spare production capacity, and the still strong, albeit slowing, global oil demand growth. Unthinkable just three months ago, $100 oil is certainly a possibility for this year.

The Outlook
Brent: Though flat prices have rallied impressively in the last week or so, spreads have remained subdued. Brent is really getting it from both ends. The physical markets remain well supplied at a time when the Saudis are already placing more barrels. Moreover, while the flat price is starting to price in the loss of Iran barrels going forward, the Iranians are still pushing barrels into the market and haven’t gone away just yet. And, US exports remain very strong, especially with Cushing now pricing to refill, forcing USGC crude differentials lower to shut the pipeline arbs from Cushing, but in turn keeping export arbs open, thus encouraging exports out of the USGC. In many ways, however, this is the calm before the storm. Eventually, the USGC will price to attract barrels once Cushing has refilled, or else USGC tanks will go to bottoms, and with most of the Asian market now trading August barrels, the November Iran deadline looms. As buyers of Iranian crude seek alternatives, and as US exports slow down, we feel Brent will be in a strong position to perform. From a flat price perspective, technicians are focused on $77.75 per barrel, which is the 50% Fibonacci retracement from 2012 high to 2016 low.

WTI: Right now, WTI spreads are pricing to refill Cushing. A power outage last week at the 0.35 mb/d Syncrude Mildred Lake upgrader has led to a significant tightening of Cushing balances, which were already set to hit tank bottoms in July following the expansion of the Ozark pipeline. Unsurprisingly, this has lifted differentials of sweet and synthetic crude grades. The upgrader is not expected back online until the end of July. We have thus lowered our Canadian production numbers in June by 70 thousand b/d in June and 0.3 mb/d for July. With less synthetic crude headed to the Enbridge system, we expect the space on the pipelines to be replaced with both light and heavier crudes given strong pricing across both grades. The problem is that because of the spike in WTI, the Gulf Coast grades need to do the work to allow Cushing to fill, but at the same time that leaves the export arb open, pushing more barrels to Europe. This situation will reverse at some point, and the USGC will have to price to keep barrels from being exported.

Fig 3: WTI and Brent, M2 vs M12, $/b Fig 4: Brent CFDs, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Yasser Elguindi, Energy Market Strategist
+1 646 798 1700 (direct)

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