OPEC+ and its members have been deliberating over the past few days to reach a decision as to how much oil should be released in August and how long they should keep the existing production cuts agreement in place. When oil demand was on the verge of collapsing last year, Saudi Arabia and Russia could not have timed their production disagreements at a worst time, which led the former to teach the latter a lesson by flooding the market with all the excess oil they had just at a time the world was entering permanent shutdown! Even they did not expect oil to have fallen to levels that it did as Brent Oil went from $70/bbl. down to $20/bbl. in just a few months!
President Trump managed to broker a deal to save the U.S. economy and its shale producers who went bankrupt overnight, whereby OPEC+ members agreed to take off about 10 mbpd of oil out of the market in April 2020. As prices normalized and slowly recovered, all OPEC members and their partners cheered in unison as their future spending plans seem to be on track.
Now, this is where it gets interesting. When the OPEC+ pact was drawn last year, production baselines were set according to October 2018, except for Saudi Arabia and Russia, which were both given the same baseline level of 11 mbpd. Each country measures its production cuts or increases against a baseline. The higher that number, the more a country will be allowed to pump. The UAE, which is a relatively minor producer, saw its baseline benchmarked at slightly lower levels of April 2020 at 3.16 mbpd. It too wants its benchmark adjusted to the higher level of 3.841 mbpd.
OPEC+ has been releasing oil slowly into the summer, but there it is still keeping about 5-6 mbpd of oil on the side-lines. The current proposal is for OPEC+ to release 400k bpd oil starting from August till December and to extend the current existing product cut agreement beyond April 2022. All OPEC+ members have agreed to this except for the UAE. Talks last week were postponed for this week, and as of Monday evening, they have been called off altogether, without a future date.
To understand the relevance of this dispute, one needs to look at the history of Saudi Arabia and UAE. These two have most always been in sync with each other's geopolitical and foreign policies. We have rarely seen the two dispute. But now as domestic economic policy and revenues takes hold, each state has to look after their own revenues as its future survival depends on it. As physical markets have tightened, with the front spread shooting to backwardation, one wonders why OPEC is still holding back so much oil.
Time and again we see boom and bust in the oil market. Since the U.S. shale revolution back in 2014, the dynamics of the oil market changed forever. From OPEC being the swing producer of oil, U.S. shale took the spot over the past few years. But last year it lost about 2 mbpd of oil during the oil price collapse, and U.S. oil companies are trying to be more disciplined this time around by keeping their shareholders happy. And OPEC is back in the drivers seat.
Putting this dispute into context, the two countries are arguing about who should be allowed to produce "more" of their existing oil. There is no shortage. The headmaster is just playing bully to keep all the other member states in line.
The summer months tend to have strong demand period for oil, given driving miles and power cooling demand. International travel has not fully opened yet, so an argument can be made for incremental demand to come through into the 2H21 of this year as travel picks up. Another factor aiding oil prices are the macro inflows into commodities as an asset class given the inflation backdrop of the economic cycle. This always tends to exacerbate prices both to the upside and downside outside of OPEC's control.
OPEC+ can play all the games it wants, but the longer this charade continues, oil prices will keep grinding higher, reach a level where it will pinch the pockets of the average consumer and CPI forecasts, and curtail demand. Alternatively, if it goes much higher it may even tempt U.S. producers to finally come back in and drill more.
There is no shortage of oil, it's a timing game being held back for as long as possible to get the best price possible to perhaps sell some assets at the top just at the time when everyone is long oil for the reflation trade and every sell side bank is pushing for super cycle oil prices of $100/bbl. Brent. Go figure.
