The Organization of the Petroleum Exporting Countries (traditional OPEC as we know it) and other producers such as Russia (OPEC+ in slang) agreed last December to reduce supply by 1.2 million barrels per day starting Jan. 1 for six months. Most of that burden has fallen on Saudi Arabia as other members have been constrained; its oil production has declined to 10.136 million barrels per day from 10.24 million barrels per day in January.
Just a few days ago, it announced its intention to cut its crude exports to below 7 million barrels per day, keeping its output well below the 10 million barrels per day it had promised to do. Saudi Aramco's oil allocations for April are 635,000 barrel per day below customers' requests. This comes despite the rise in Brent oil's price to $67 per barrel from $52 per barrel in December, as it seems bent on supporting prices even further, to President Trump's detriment. What is going on here?
OPEC learned its lesson last October when Iran sanctions were supposed to kick in, tightening the market, and it promised to raise production to accommodate the belligerent Trump. Given India, China and rest of Europe's adamance, there were always going to be exceptions to the waivers given the geopolitical backlash. Most importantly, OPEC did not see the global growth slowdown hitting commodity prices as the fourth quarter of 2018 spiraled toward a recession, taking all victims, including oil, down with it as demand fell across the board.
Demand is unfortunately a hard part to forecast in commodities. Analysts are very good at extrapolating past trends to future forecast as opposed to analyzing the current trends at hand and trying to predict the future outcome. That's where hedge funds come in; we are taught to forecast what can happen, not what has happened.
We know most OPEC countries need oil prices of about $60 to $70 per barrel. Brent oil, to balance their budgets with the Saudis, must be closer to $90 a barrel. It is an extremely delicate matter how they desire to balance the market versus balancing their budget while keeping their allies happy. A slow and gentle grind higher will perhaps not be noticed.
Venezuela has thrown a monkey wrench in the works of this process. The civil and political unrest, including the country going bankrupt, threatens its oil production and supplies by about 1 million to 1.5 million barrels per day. Following the recent blackouts on Sunday, Venezuela's main oil export terminal and its heavy crude processing complex in Jose are shut with capacity of 450,000 barrels per day down.
Needless to say, Venezuelan oil is generally at risk as no one knows how bad the situation can get. More importantly, all this oil is heavy oil, unlike U.S. shale oil, which is light oil. The type of oil is important as that dictates the arbitrage possibilities between different regions.
OPEC, which has been cutting its oil output, is also heavy oil. The world is getting short heavy oil and has excess of light sweet oil (U.S. shale). This is a classic game played among pure physical commodity players. At a time, when oil market is getting tighter with OPEC hell-bent on taking all the excess oil out, the Venezuelan situation will succeed in supporting oil prices for longer.
US oil production last week hit an all-time high of 12 million barrel per day, up 2 million barrels per days from a year ago. It exported a record 3.6 million barrels per day of crude, putting it ahead of every OPEC country barring Saudi Arabia and Iraq.
It goes without saying that Saudi Arabia is losing its market share to the U.S. as it cuts its production. Refineries, especially U.S. refineries, have been upgrading their systems over the last decade to be able to process heavy oil given its abundance in the past to produce distillates. With the current shortage for the right type of oil, these refineries need to find substitutes, creating havoc in the system.
Oil's price is fairly valued here. Certainly, the actions from OPEC to keep the market balanced will keep a floor under oil prices for now. The risk here is of a macro-driven slowdown given the disconnect between equities, bonds and other asset classes. Bond markets are trading higher and printing lower yields, whereas equity markets seem to be gung-ho about recovery and growth prospects despite lower forward earnings expectations. They seem to be ignoring the hard data.
Typically, bond and foreign exchange markets tend to be more sophisticated, so this seems to ring a dangerous alarm bell. If equities start falling on back of recession fears or if liquidity dries up, so too will oil fall as demand once again will be the problem. Whether this happens now or after the winter heating season is anyone's guess, but considering that macro warnings abound, it is best to not be involved on the long side until March catalysts clear with the Federal Open Market Committee (FOMC) meeting next week and U.S.-China trade deal details released, not just headlines of some deal.
