OPEC members met in Vienna over the last two days in their June session to decide the fate of oil production quotas -- or at least to make the appearance of a decision.
Key member Saudi Arabia and non-member Russia had met earlier over the weekend on the sidelines of the G-20 meeting in Osaka to make their own decisions, prior to the actual Vienna session. (One wonders why they carry on with the formalities of hosting the OPEC meeting other than to make all the other members feel like they are involved: Russia and Saudi Arabia decided to keep cuts in place and the wording of the agreement was drafted in Vienna.)
But to put it bluntly, there is no shortage of oil.
Let's look at how things had unfolded. In late 2016, the group announced the cuts that would last just 6 months. Then, in mid-2017, it extended the cuts by 9 months. Then it extended them another 9 months. OPEC is clearly buying time as it has no idea what demand will be, or how President Donald Trump decides to pursue his trade war with China, and rest of the world.
The group of petroleum exporting nations was closer to increasing production during the spring, prior to Washington's previous escalation of its trade war with China that saw Brent crude oil prices eventually fall to around $60 per barrel from $72.
About 1.2 million to 1.5 million barrels per day of cuts have been in place since 2017. But to OPEC's detriment -- a bit like in the Fed's case -- every time it see prices hover below $60 a barrel, it decides to extend the cuts a bit longer, sound familiar?
The only known fact is that OPEC cannot afford to see prices stay below $60 a barrel, as their budget-spending plans depend on it.
Secretly, OPEC is happy with prices close to $70 a barrel. But, really, their break-even is closer to $80-$90 a barrel. But the group cannot publicly admit that, lest it wants to upset Trump.
Saudi Arabia said it would measure the surplus of crude oil inventories based on the 2010-2014 average rather than the average over the last five years. This implies draining an additional 160 million barrels of oil off the market, according to Bloomberg calculations.
There is a lot of talk about Saudi Arabia taking up the slack and conceding market share to other players, including U.S. shale, to help support prices. But there's more to this than meets the eye. Thanks to shale, U.S. production has grown to around 12 MBPD in April, from levels closer to below 9 MBPD few years ago. Previously OPEC was the swing producer, now U.S. shale and Russia play roles, too.
The composition of OPEC's oil production has changed drastically over the last few years, namely in Iran and Venezuela. The secular decline and trade sanctions have caused them to be in perennial decline. Venezuela produced and exported close to 2.5 MBPD in 2016; today it is exporting less half that amount. In 2018, Iran's exports of crude oil and condensates was around 2.7 MBPD. The shortfall from these two players has been met by an increase in Saudi Arabia. Yes, OPEC's market share has fallen to less than 30% of the global oil market, but Saudi Arabia's share really has not changed.
In fact, it has stayed quite stable. Revenues are of prime importance to them. Seems like a win-win for the key members.
After the market decline in May, Fed Chair Jerome Powell capitulated on his hawkish stance yet once again, which helped the S&P 500 rally 7% off its lows, taking other asset prices -- including oil -- up with it. Brent rallied 10% to $66.5 per barrel, as the dovish lower-for-longer rates trade overtook the markets.
As portfolio managers, we like to think we generate alpha, but over the last year and half, it has just been one trade in the market: risk-on or risk-off. This dynamic is beyond OPEC's understanding as they are able to see the supply, but unable to forecast the demand.
Global Purchasing Managers' Indexes are contracting across the board (printed below 50 yesterday), not only in Europe, but in the rest of Asia. Trump and China's Xi Jinping may have decided on a truce over the weekend, but the fact is that 25% tariffs on $200 billion worth of goods is still in place and affecting global trade across the board.
Some of the more sophisticated asset classes like bonds, rates, and currencies have been screaming "sell risk" for the past few months, but equities are merrily humming to their own tune.
The divergence can only extend for so long on hope and optimism, but when real numbers hit the tape, even the bulls will feel their core shaking, unable to defend their longs at the market top. The Fed can rescue the market, but only if it falls from here. If it does not, the Fed won't cut rates and the dollar will rally, which will hurt commodities, as everyone has jumped on the band wagon that Fed will start cutting aggressively.
Earnings are coming in the next few weeks, with the market overall showing second consecutive quarter of year-over-year declines of 2.5%, and energy down about 6% year-over-year. The energy majors have had their run and are a source of shorts, and regardless of their dividend-paying abilities, the top line is declining.
We are entering peak-summer driving season, which can boost U.S. demand, but with a surplus of product inventories, prices are at best capped, if not doomed to fall lower as the optimism over the G-20 trade war deal unwinds.