Since the highs of $77/bbl. back in July, Brent Oil has now fallen more than 10%, briefly falling to sub $70/bbl. But the market seems unconvinced despite the majority of sell side analysts calling for the market to enter a super cycle phase with prices that could reach as high as $100/bbl.! At the start of the year, when the market was going through the recovery/reopening phase, the demand snapback was pronounced which caused prices to rally quickly.
Prices shot much higher because the OPEC+ group decided to hold off about 5-7 mbpd of oil out of the market since last year when the original 10 mbpd of oil production cut was agreed upon in April.
This so called "supply tightness" was engineered at a time when the world was emerging from post lockdown world with demand rebounding. Despite prices going as high as $80/bbl., OPEC+ has been very slow at bringing their production back, lest they disrupt all the progress they have made. By progress, it means more revenues of course. If the market is really as tight as the analysts claim, then why is the price not moving much higher?
Since 2012, when U.S. shale oil rocked the world of oil, we have witnessed many mini oil cycle rallies, but the price has never really claimed that old all-time high of $147.5/bbl. Brent in 2008. The balance of power changed as the U.S. grew its oil production to highs of 13 mbpd close to Saudi Arabia's 11 mbpd and Russia's 10 mbpd. It moved from being a net importer to a net exporter in a few years as shale oil made the cost of oil so much cheaper, not to mention shorten the production cycle.
As long as WTI is above $45/50/bbl., U.S. domestic producers are incentivized to keep pumping as drilling is economical. They then became the swing producers of the market and Saudi Arabia, with its OPEC alliance, had to keep cutting oil to keep prices stable only to benefit U.S. shale drillers. All of this changed last year, as prices slumped down to -$37.5/bbl. U.S. domestic oil production has not recovered after permanently losing about 2mbpd of oil.
There is a lot of pressure on the U.S. drillers to be disciplined this time around and not keep pumping for the sake of it given their negative free cash flow profile of the past few years. This is one aspect that has helped OPEC+ be in the driver's seat as they know the U.S. is unable or unwilling to come back despite prices being much higher.
At a time when demand was picking up and U.S. shale unable to increase their production, the lack of OPEC+ supply increases caused a double whammy effect which caused inventories to drop quickly and spreads to tighten. As inflation views got more pronounced in the street, commodity funds saw inflows which caused the price of oil to rally even more, especially the front end.
Call it the trifecta effect. In a short window of time the confluence of these factors helped oil. However, over the past few months, something has changed. Demand is slowing down as Asian imports have fallen and the market is dealing with this deflationary setback. To add insult to injury, OPEC+ has decided to increase their production, albeit in dribs and drabs by 400kbpd from August through December. From macro tailwinds, the oil market is now seeing macro headwinds.
The world has yet to understand how infectious the Delta variant is, and slowly more and more countries enter into an extended lockdown phase which delays travel demand pick up. At the end of the day, the oil market was never tight or in shortage. It was only tight during a short period of time when all factors were in its favor. The supply side of oil is much easier to track, but demand remains the big unknown.
And we know that analysts are very good at extrapolating past demand trends assuming a linear future, but only making the necessary adjustments after the fact.
