I still know what you did last summer

Published at 12:59 12 Apr 2019 by . Last edited 11:18 22 Aug 2019.

Due to the Easter holiday the next Digest will be published on 26 April

The sequel to the cult classic movie ‘I know what you did last summer’—one of the seminal horror films of the 1990s—begins by highlighting the main antagonist’s difficulty getting over the events of previous summer, haunted by nightmares and fearful of repeating the mistakes of the past that ultimately led to the cataclysmic events. This in some ways explains the attitude of OPEC ministers as they begin to think about their summer production profile, especially as Donald Trump is again trying to browbeat producers into pre-emptively increasing production to enable him to further squeeze Iran by reducing the country’s exports as much as possible.

This is a movie that the Saudis have seen before, and they are not interested in a sequel. Still, re-watching the DVD might be instructive given that despite all the efforts of the antagonist not to repeat the same mistakes…they were in some way inevitable (otherwise there couldn’t be a sequel).

Horror shows aside, separate comments this week from OPEC ministers and Russian President Vladimir Putin should put to rest any question over the commitment of all sides to the OPEC+ agreement. These comments reinforced that, Trump tweets aside, there is near universal comfort with the current level of prices. Moreover, it was clear from statements made by all that there is unlikely to be a move to increase supply beyond the December 2018 targets until there is a clear signal from the market to do so. If anything, OPEC ministers remain laser-focused on conformity with the cuts, suggesting there will be strict monitoring of compliance straight through June.

Fool me once, shame on you
One of the big problems last summer was the unilateral Saudi decision to increase production and exports without first prepping both OPEC or the markets ahead of time. That is a mistake that will not be repeated. If the group is to start increasing production, it is likely to be well telegraphed in advance.

Earlier this week, the Saudi energy minister signalled that the Kingdom is preparing to modestly increase production when he noted in an interview that he “no longer sees the need for the Kingdom to produce below its quota level”. Since March, Saudi has been producing around 9.8 mb/d, roughly 0.5 mb/d below its quota target of 10.3 mb/d, with much of the cut aimed at volumes going to the USGC, due to a fear that US inventories would again balloon and keep downward pressure on prices.

However, the minister was also clear in saying that inventories still need to fall further, by roughly 70 mb, in order for the market to be balanced, suggesting that even though Saudi Arabia would increase production in the coming months, it would still keep a tight leash on output in order to keep the market in deficit and thus ensure that inventories continue to draw.

Fool me twice, shame on me
US President Donald Trump last week tweeted about the need for lower prices again, and this week Trump spoke directly with King Salman of Saudi Arabia, reportedly asking him to increase production, so that the US can maintain a maximum pressure strategy vis-à-vis Iran. We understand that the Kingdom has told the US that it will respond to any deficit that may emerge in the market in order to keep it in balance. The point here again is that the Saudis are emphasising that they are only happy to respond after the fact.

As if to emphasise that point, UAE energy minister Suhail al Mazrouei spoke directly and candidly at a conference this week in Abu Dhabi, when he was asked about the production surge in 2018. The minister could not have been clearer, saying that the organisation would not repeat the mistakes of last year by trying to pre-empt the market and increase production before they had a grasp of how much the Trump administration was going to reduce Iranian exports. When asked about Iran sanctions waivers the minister answered:

“I think we got a bit carried away and we took it for granted that those volumes were required. We struggled in Q4 and Q1 as a result of that decision. We will not do that again. We have learned the lesson, we will do what is required to balance the market, but we are not going to jump the gun and pre-produce volumes that are not required yet and we need to see the requirement for those volumes first”.

Perhaps the most instructive comment on current thinking in Riyadh came from Khalid al Falih, the Saudi energy minister, when he said that the Kingdom is not yet feeling stressed about current prices, declining to characterise them as ‘high’. When asked about the rapid increase in prices in Q1 19, he appeared sanguine by the return to $70 per barrel, noting that prices are only up from a “very low baseline”, and called into question whether “[we can] really say prices have rallied so much this year”.

These comments again reveal an internal bias within OPEC that prices have room to move higher, that members will not increase production to pre-empt the potential tightening of sanctions on Iran and/or Venezuela, and, most importantly, that the organisation remains more focused on conformity with the existing cuts rather than potential increases in production in June. Given the timing of the comments from ministers in Russia, Saudi Arabia and the UAE, and the near uniformity of the message, it is hard to believe that this wasn’t coordinated. The narrative should begin to flip from whether OPEC can defend the downside to prices, to whether the group can manage the upside without losing control of prices.

May meeting in Jeddah will be decisive
The 19 May JMMC meeting in Jeddah is clearly where a lot of the assumptions for the decision-making at the June meeting will be hammered out. One of the reasons that the April extraordinary meeting was scrapped was that OPEC would not have had enough visibility on Q1 19 inventories, nor would they know whether the Trump administration would renew Iran waivers, or what the production profile of Venezuela would look like. However, by May, the organisation should have complete Q1 19 inventory data and preliminary April data. They should also have a better idea of the extent of Venezuelan production declines and the outlook for H2 19. And they will also know whether the Trump administration has decided to push Iran’s exports to zero or to extend the current waivers for another six months, which will be announced by 2 May.

By the time of the June meeting, we would expect Saudi production to be back up to 10.3 mb/d. April nominations were awarded more than a month ago, so we don’t anticipate much deviation in Saudi production and exports for the balance of this month. We expect slightly higher production volumes for May at roughly 10 mb/d (up from 9.78 mb/d in March). Of course, given that seasonally Saudi demand tracks higher over the course of the summer, there is no guarantee that Saudi exports will be higher. Again, Saudi officials stress that they are not interested in shocking the market and are highlighting the importance of gradualism and transparency. In the end, only time will tell, as exorcising the demons of 2018, when the Kingdom shocked the market with a unilateral production surge of 1 mb/d, will not happen overnight.

The market is much tighter than this time last year
The biggest irony of course is that this time last year there was actually no market signal whatsoever that an increase in production was necessary. Most differentials were trading at ‘normal’ levels, inventories had been falling, but there was not yet a mad scramble for barrels. The sanctions on Iran had just been announced, and refiners had not yet started to ask for more barrels. If anything, many refiners were surprised when the Saudis uncharacteristically started offering higher volumes to buyers, in some cases beyond the normal 10% variable threshold.

This year is exactly the opposite. Every single crude is backward, and refiners are scrambling to try and find barrels to replace lost Venezuelan and Iranian volumes. Most crude differentials are at seasonal and in some cases multi-year highs, again reflecting the strong desire for more oil. Meanwhile, Saudi OSPs are at historical highs, and refiners tell us that Aramco is not at all pushing barrels on them. At these OSP levels, refiners will either try to find an alternative barrel that is more attractively priced, or they will simply choose to trim runs. Iraqi OSPs are even stronger than the Saudi ones and other GCC members have followed suit.

Fig 1: Saudi production vs quotas, mb/d Fig 2: Various OSPs, $/b
Source: Energy Aspects Source: MEES, Argus Media Group, Energy Aspects

The point here is that this market is screaming for more oil, but the Saudis still want inventories to tighten further, and thus will be keeping a lid on supply, even if they increase production modestly back to its quota level by June. The Kingdom is absolutely in no rush to bring more crude to the market.

Pick your poison
Of course, given that OPEC and Russia remain reactive to fundamentals (and by default to price), there is a growing risk that the group gets the timing wrong and overtightens the market, regardless of intent. This is where our outlook for Q3 19 becomes tricky. We have assumed a very large increase in refinery runs from Q2 19 to Q3 19 of roughly 1.7 mb/d, based on our expectation that refiners will need to run hard in preparation for IMO 2020. However, if refiners are unable to find adequate crude supplies, and margins remain depressed due to the strength in crude, it is possible that refiners will instead simply chose not to run—like last November when they were unable to source enough crude in September and so cut runs by roughly by 0.7 mb/d.

If something similar were to happen over the coming summer, and runs don’t rise by as much as we currently expect, then crude stocks would not draw as much as implied in our balance. However, it would mean that product stocks would draw heavily instead. Given that product stocks in some parts of the world are tighter currently than crude, this would then give refiners an incentive to run even with the higher crude prices. Thus, this becomes a timing question. There is no doubt that inventories will draw in Q3 19, but the distribution between crude and products is not yet clear. Analysts will have to pick their poison.

Fig 3: Energy Aspects global crude balance, mb/d
Source: Energy Aspects

My chemical bromance
Ever since its inception in Algiers back in September 2016, most in the market never truly believed in the durability of Saudi-Russian cooperation or what you might call a bromance between Putin and MbS—a relationship born by necessity as much as convenience. Thus, as each subsequent meeting approached, there has always been a latent expectation on the part of the market that Saudi Arabia and Russia would be unable to bridge their differences, and that they would effectively ‘break up’, bringing an end to this brief period of cooperation, and the Saudis would go back to November 2014 production levels and make a swift grab for market share, thus crashing the oil price once again. Remarkably, despite 2.5 years of fairly seamless cooperation between the two sides, those fears remain. But the reality is that the bromance has survived and has been looking more and more durable with each meeting.

On two separate occasion this week, Vladimir Putin reemphasised Russia’s commitment to working with the Gulf producers to manage supply, even if both sides still had to decide what that supply level will look like in H2 19. Noting that he was very comfortable with current price levels, he added that "We are ready for co-operation with OPEC in reaching decisions. Whether it would be further cuts, or a halt at the present level of production, I am not ready to say… but we do not support uncontrollable price rises”, Putin told an industry gathering in St Petersburg on 9 April (we would note that he did not list an increase in production as one of the options).

Thus, it seems that OPEC and Russia are willing to see Brent prices rise back to $80 per barrel before they contemplate tinkering with the supply levels agreed to in November 2018. This means that Saudi Arabia can increase another 0.5 mb/d between now and the June OPEC+ meeting and still credibly agree to an extension of the existing agreement through to the end of the year as it would still be abiding by its quota. We still think the market is discounting the degree to which there is pressure from the leadership in Riyadh for the energy ministry to deliver higher prices.

Something’s gotta give
It remains unfathomable to us that the Kingdom will not meaningfully increase production in H2 19 given the massive supply hole that is beginning to emerge. We have been extremely conservative in our forward balances. We already assume Saudi production will rise to 10.7 mb/d by the end of Q3 19 and for the balance of Q4 19, Iran broadly flat in H2 19 vs H1 19 (as we now assume waivers get rolled-over at current levels), and Venezuela stabilising just above 0.7 mb/d through the end of the year (current production in Venezuela is probably around 0.3 mb/d lower than that), and yet we continue to see extremely large crude draws for Q2 19 (1.1 mb/d) and Q3 19 (1.7 mb/d). Should the Trump administration squeeze Iran further, or if Venezuelan declines accelerate, or even if OPEC+ simply extends the existing supply agreement to the end of the year without increasing production, then those Q3 19 draws could look even bigger. If that is the case, then there is a significant risk that OPEC will lose control of prices to the upside, overtightening the market, and all that comes with it. In a perverse kind of way, a dramatic oil price shock that tips the global economy into a recession would bail out the Fed, which could then drop interest rates to zero again, and allow the economy to pivot, instead of trying to extend an already overstretched business cycle. But who on earth would ever wish for that?

The Outlook
Brent: While WTI timespreads came under pressure (see below), Brent spreads rallied as fundamentals remain constructive. Differentials across Asia and the Atlantic basin remain at seasonal, and in some cases historical, highs. The loss of Venezuelan volumes has begun to drain the Atlantic basin, in particular of distillate-rich WAF crudes (as we have been saying for several weeks now), which served to tighten the crude fundamentals demonstrably. Moreover, even weaker product margins are more a function of strong crude more so than weak products, especially given how gasoline has performing of late. Essentially, where crude differentials are strongest is where margins are struggling the most (the exceptionally strong Urals prices for this time of year are a clear example). With OPEC continuing to keep a tight lid on supply and still keen to reduce inventories, coupled with all the risks to supply that still exist (e.g. Venezuela, Iran and Libya), there is no reason in our mind to short Brent spreads in the near term.

Fig 4: Urals NW diff to dated Brent, $/b Fig 5: Prompt Dubai timespread, $/b
Source: Argus Media Group, Energy Aspects Source: Argus Media Group, Energy Aspects

WTI: Over the last week, we have been suggesting that the very strong move in WTI spreads was perhaps overdone, given the unwind in positioning, and was due for at least a pause. WTI timespreads sold off aggressively late in the week, and the curve gave back some of the strength it had gained in the last month as Midland differentials unexpectedly collapsed, reopening the arbitrage to Cushing from the Permian, such that both the Basin and Centurion pipelines are now expected to be full, pushing up Cushing stocks in the coming months. Alongside that, and despite a stronger Canadian market north of the US border, significant maintenance at Chicago-area refineries—including Exxon Jolliet and BP Whiting—should increase flows from Chicago to Cushing on Flanagan South or Spearhead. And, eventually, the Keystone Pipeline will divert its flow back to Cushing as its nominations are sorted between Patoka and Cushing. Taken together, Cushing stocks are set to build in the coming weeks, easily hitting over 50 mb by June. This eventual pause in Cushing draws will continue to weigh on late length into the WTI complex, both WTI spreads—which should weaken towards a total cost of capital, pump-over costs, plus a normal profit on storage summing to around -25 cents per barrel—while WTI-Brent should widen back to double-digit discounts again. WTI-Brent has the added pressure of what we expect to be a strong Brent market on the back of North Sea and Mediterranean upstream maintenance.

There is much speculation about the cause of the dump in Midland differentials this week with rumours running rampant that there has been a delay to the EPIC NGL conversion slated for July start-up. However, the company’s FERC filings say the pipe will be completed between April and June; so, assuming linefill in July, the start-up will not be before August. This would qualify as a delay of one month versus consensus expectations but not as bad as some in the market have suggested. As we have said before, the timing of these pipelines will be meaningful for the Cushing balance, and thus for spreads going forward.

Fig 6: Midland diff to WTI, $/b Fig 7: Jun-Jul WTI timespread, $/b
Source: Argus Media Group, Energy Aspects Source: Bloomberg, Energy Aspects


Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)

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