Perception vs reality

Published at 10:50 27 Sep 2019 by . Last edited 13:05 27 Sep 2019.

In the oil market, perception is sometimes more powerful than reality. Right now, the perception is that the market is extremely well supplied, demand is weak and peace is about to break out in the Middle East. After spiking dramatically on 16 September, the Monday after the attack on Saudi oil facilities, flat price has since filled the gap (see Figure 1) and, perhaps more shockingly, the Brent crude curve is now back to where it was the week before the attacks. Two things have driven this retracement lower despite the massive hole in global supply created by the outage at the Kingdom’s Abqaiq processing facility (see E-mail alert: Saudi Arabia restarts 2.5 mb/d of production, full capacity will only return by end-November, 18 September 2019). First, the Saudi leadership has made it clear that it will go to great lengths to get Abqaiq back up and running. But part of that calculation is political, as spare capacity is Saudi Arabia’s main strength. As such, a steady stream of headlines coming from ‘sources’ stating that capacity is coming back faster than anticipated has meant that some of the initial fears over supply are fading. Second, there is a stubborn and growing expectation that the US is on the verge of lifting its sanctions on Iran as part of a broader ‘deal’ between the two countries. In both cases, the perception is much stronger than the reality, and hence why prices remain weak.

Fig 1: Prompt Brent crude price, $/b Fig 2: Brent crude curve, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Certainly, part of the price action has also been driven by US producers, many of whom perhaps thought that prices were about to shoot higher and wanted to take advantage of the higher price to lock in hedges on 16 September. But just as fast as prices rose on that day, they subsequently fell, leaving many producers locking in December 2021 production at $51–53 per barrel. (It’s worth noting that there now are a number of US producers that are locked in at a much lower price than they had anticipated, but that’s a conversation for another time). Clearly producers that had initiated hedges thinking prices would be higher were overwhelmed by the pace of selling, and together with the perceptions around Saudi and Iran, prices cracked.

Riding through the desert on a source with no name
While the market continues to gyrate in response to every headline on Saudi production, we think it’s important to note that since the initial press conference on 16 September there has been no official update on the status of oil production from either the Saudi oil ministry or from Aramco itself. Earlier this week, a slew of press reports suggested that Saudi capacity had reached 11.3 mb/d, much faster than the timeline proffered by the oil minister in the initial press conference. Reuters quoted ‘people briefed on Saudi Aramco’s operations’, while Bloomberg quoted ‘people with knowledge of the situation’. Many have ridiculed the monikers such as Gulf sources or sources familiar with the situation. But the whole point of these tags is to provide deniability. There may have been political reasons for someone in the leadership to float that 11.3 mb/d number, whether it’s the looming Aramco IPO or to instil confidence in Western capitals that Saudi can still be the supplier of last resort. But it’s important to remember that these were not official Saudi statements. Our soundings indicate that production currently remains at just above 8 mb/d, and that it could still be at least weeks rather than days for the Kingdom to approach pre-attack output levels.

Of course, we outlined last week that the Saudis are moving heaven and earth to keep their commitments to the export market. Aramco is basically destocking, starving its own refineries, buying crude on the spot market and buying products as well in order to meet its obligations. But for the market, this will appear like Aramco is delivering supplies to the market and there is no disruption. But these supplies are not all from production: the Saudis are tightening global inventories, tightening product markets, and bidding up spot crude to fulfil these commitments.

All of this will eventually show up in inventories, but it may take a month or two for this to become apparent. Meanwhile, the Saudis have also had to notify customers that it will not be able to deliver the grades promised in some cases, with several Asian refiners being told they will receive Arab Medium instead of Arab Light. This will have implications for product yields. Finally, as Saudi Arabia scrambles to bring production back, it’s very likely that there is going to be zero spare capacity for a period of months, well into 2020.

In short, while the market is pricing as if there is nothing wrong, the reality is that this outage is going to leave a hole in global balances and has left the market incredibly vulnerable to further outages. But you wouldn’t know that by looking at the flat price.

Irrational exuberance
The other reason for the sell off in crude post Abqaiq is the almost irrational belief that the US and Iran are on the verge of entering discussions that would lead to the removal of US sanctions on Iran. While we agree that President Trump would love a photo-op with the Iranians, and acknowledge that there have been intense mediation efforts from French President Macron and Oman to facilitate a meeting between the US and Iran, we have long maintained that Iran has no interest in meeting. Indeed, this week at the UN, Iranian President Hassan Rouhani confirmed that Iran will not meet with the US until it has done three things: lift sanctions, return to the 2015 nuclear deal (the JCPOA), and agree to meet Iran in a multilateral framework rather than bilaterally. All three are non-starters from the US position, and yet the market still is convinced that there is a super-secret backdoor channel that is going to lead to a deal. In reality, Trump will not lift sanctions in order to facilitate negotiations, and the Iranians will not negotiate unless sanctions are lifted. Neither side yet feels enough pain to climb down, and until one side does, talks aren’t going to begin.

This week’s frenzied market chatter about an imminent deal also fundamentally misunderstands US policy towards Iran. President Trump keeps saying that he does not want a war, but that does not mean that he wants peace either. Moreover, just because the two sides would sit at the negotiating table does not guarantee that a positive outcome would result. The Iranian position has been clear and consistent from the very start: they would be willing to make modest tweaks to the JCPOA, but any deal must have the JCPOA as its fundamental basis. Trump has also been consistent in saying that he wants to tear up the deal. The Iranians simply want to supplement the JCPOA, while the US wants to supplant it. The two sides are no closer to real talks despite a summer of back-channel efforts, so we think that expectations of a US–Iran deal are mightily overblown.

EU3 + 2 < P5 + 1
In the immediate aftermath of the oil facility attacks, the market was girding for a military response by the US and Saudi Arabia. But over the course of last week, both countries decided to hang fire. This is partly because both were surprised at the scale, audacity and precision of the strike and quickly realised that striking back right now would leave them open to retaliation by Iran, as neither Riyadh nor Washington had the assets in place to defend against. Instead, the Saudis have been working hard to present evidence to the international community that Iran was the source of the attack to shore up support. For its part, the US has been mobilising personnel and assets to beef up its defensive forces in the Kingdom. The Pentagon this week announced it was deploying at least one battery of Patriot missiles, four Sentinel radars and roughly 200 support personnel to augment Saudi Arabia’s defence of critical infrastructure.

Riyadh’s attempt to win international support has yielded some success, with Germany, France and the UK this week stating that the evidence clearly pointed to Iran as being behind the attacks. But the EU3 also called for new diplomacy to avoid conflict, stating that Iran must “accept a long-term negotiation framework for its nuclear programme, as well as regional security issues, which include its missile programmes".

The market, as it has done several times before this year, appears to have mistakenly judged that the lack of an immediate retaliation on the part of either Saudi Arabia or the US as a signal that the US was backing down on its campaign of maximum pressure. Rather the US is making sure that it has adequate tools to defend the Kingdom from further attack, but also to increase the sanctions pressure on Iran. The US has no intention of loosening the economic noose around Tehran. The US is quite happy to wait, months or years even to get Iran to capitulate and come to the table. If anything, the US is doubling down on its maximum pressure campaign until Iran comes to the table with no preconditions.

Though Iran may not yet have crossed any of the red lines that we think would trigger a direct US retaliation, that does not mean that the US does not have red lines. As such, we expect tensions to remain high as Iran may chose to test US/Saudi resolve again, so it’s highly likely that Iran will retaliate to any increase in sanctions, given its policy of pressure for pressure. Tensions appear to be rising, not falling, unlike the oil price.

The Outlook
Brent: As flat price has fallen this week, benchmark crude spreads continued to tighten, especially Dubai, and crude differentials continue to rise as refiners scramble to bridge the Saudi shortfall in supplies. The prompt Dubai spread is at a multi-year high, while Middle Eastern crude differentials continue to firm too. Atlantic basin spreads could come under some unexpected pressure in the near term as freight rates spike due to the imposition of US secondary sanctions on a subsidiary of Chinese shipping company Cosco, one of the largest fleets in the world (more on this below). Margins continue to improve in part due to the Abqaiq outage as the Saudis divert crude away from their domestic refineries and buy spot gasoil and fuel oil. With margins strong, supply tight and geopolitical tensions in the Middle East likely to remain high, we remain constructive on overall crude balances into Q4 19, especially once refiners get past turnarounds in a few weeks. The market continues to discount the impact of the Saudi outage, and Q4 19 draws are likely to be much stronger than many realise.  

Fig 3: Prompt Dubai M1 - M2 spread, $/b Fig 4: Freight dirty USGC - China 270kt, $/t
Source: Bloomberg, Energy Aspects Source: Argus Media Group, Energy Aspects

WTI: While we remain bullish Q1 20 spreads in WTI, there are some bearish headwinds in the near term. Last week, we highlighted lower refinery runs and other dislocations due to tropical storm activity in the USGC (see Data review: US Department of Energy, 25 September 2019). But even beyond the maintenance and storm effect on runs, there could be even more pressure on prompt WTI spreads as the imposition of sanctions on several Chinese shipping companies has wreaked havoc on the freight market with several long-haul routes, especially the US to China, jumping significantly in price. Because of the jump in freight, a couple of things need to happen to facilitate trade. Eastern grades need to increase in price and Atlantic basin crude needs to fall in price, and US crudes should be the most affected, as cargoes are cancelled leaving crude stranded. This is likely to put pressure on the prompt WTI spreads too. Some of the reaction in freight rates is knee-jerk as there is still confusion as to which ships are sanctioned and which are not. But until shippers, insurers and bankers have certainty that they will not be in breach of US sanctions, they are unlikely to take any chances on moving cargoes. But we still remain constructive Q1 20 timespreads and we would view any sell off as a buying opportunity as we think that structurally with the addition of pipeline capacity in the Permian, Cushing stocks will be trending towards 20 mb by year-end. This should provide significant upside to Q1 20 timespreads.

Fig 5: WTI Mar-Apr spread, $/b Fig 6: Brent cracking margins, $/b
Source: Bloomberg, Energy Aspects Source: Refinitive, Energy Aspects

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

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