Oil risks overheating after OPEC+ leaves output unchanged

By deciding to leave production unchanged for another month at its meeting on Thursday, OPEC+ risks causing the oil market to overheat and creating conditions for more instability in future.

The expanded group of oil exporters defied the expectations of a majority of analysts and traders that it would respond to escalating prices and an intensifying backwardation in the futures market by raising output.

But the decision should not have come as a complete surprise. It is consistent with the group’s behaviour over the last decade, and with OPEC-only behaviour for the decade before.

The group’s decision-making has usually lagged market conditions when prices are falling – but especially when they are rising.

Also read: OPEC output cut decision will impact consumer-led recovery: Dharmendra Pradhan

For all the group’s rhetorical commitment to market stability, past production decisions reveal its goal is to obtain the highest possible price in the short term.

In an environment of rising prices, the group has continued restricting output below its potential level to enjoy a temporary windfall in terms of higher prices.

OPEC+ does not have a track record of responding proactively to add extra barrels to the market to cool a rapid rise in prices and intensifying backwardation.

Extra barrels have mostly come from declining compliance among individual OPEC+ members with an existing output agreement and a rapid expansion in US shale production.

As a group, OPEC+ has usually allowed the market to overheat, until accelerating US shale production, decelerating consumption, or both, threaten to push the production-consumption balance into surplus.

Enjoying the windfall

Before the decision, front-month futures prices had returned to levels before the onset of the first wave of the coronavirus, and were in a range that has caused US shale production to increase over the last decade.

Most of the extra stocks that accumulated in the second quarter of 2020 as a result of the epidemic and volume war between Saudi Arabia and Russia have been digested by the market.

OECD commercial petroleum inventories are back in line with the pre-pandemic five-year average for 2015-2019, according to estimates prepared in February by the US Energy Information Administration.

As a result, Brent futures for the first six listed contracts have moved into a backwardation of $4 per barrel, consistent with an under-supplied market in which stocks are at or below the level desired by traders and refiners.

Brent’s six-month calendar spread has risen to the 95th percentile for all trading days over the last three decades, signalling production is running well below consumption and inventories are expected to become very low.

In the physical market, dated Brent’s calendar spread for the first five weeks is in a backwardation of 32 cents per barrel, the 65th percentile for all trading days since 2010, confirming the market is moderately tight already.

OPEC+ chose to ignore these indicators of a rapidly tightening market and focus instead on the "uncertain market conditions" and the need to "remain vigilant and flexible".

"The meeting recognized the recent improvement in the market sentiment by the acceptance and the rollout of vaccine programs and additional stimulus packages in key economies," the group said in a statement.

It urged all members "to remain on the course which had been voluntarily decided and which had hitherto reaped rewards", an implicit reference to higher prices and revenues.

Behind the curve

The petroleum price cycle appears to be repeating itself, with OPEC+ opting to continue restricting output rather than respond to falling inventories, rising prices and increasing backwardation.

The last time prices were around $70 per barrel and rising, and the market was in a similar backwardation, was in May 2019 and before that in April 2018. Key OPEC+ decision-makers made similar arguments on both occasions.

"It is critical that we don’t make hasty decisions – given the conflicting data, the complexity involved, and the evolving situation," Saudi Arabia’s then energy minister Khalid al-Falih said on May 19, 2019.

"I am not sure there is a supply shortage, but we will look at the (market) analysis. We will definitely be responsive and the market will be supplied," Falih said a day earlier when asked whether an increase in output was on the table due to oil shortage concerns.

The previous year he had made a similar point. "If we have to err on over-balancing the market a little bit, so be it. Rather than quitting too early and finding out we were dealing with less reliable information... stay the course and make sure that inventories are where the industry needs them," al-Falih said on February 14, 2018.

Different this time?

OPEC+ appears to think this time will be different, because shale producers have been chastened and no longer have the financial resources for a major expansion in output, after two slumps in the space of half a decade.

"‘Drill, baby, drill’ is gone for ever," Saudi Arabia’s energy minister Prince Abdulaziz bin Salman said on Thursday. "Shale companies are now more focused on dividends."

OPEC+ appears to be gambling shale producers will remain on the sidelines, at least for some months, and this gives it more scope to enjoy a longer period of higher prices without risking another slump.

US shale industry leaders have been preaching their new-found conversion to a strategy of production restraint at industry conferences recently.

But both shale producers and OPEC+ said similar things during 2017 and 2018, in the aftermath of the last price slump, and the promised drilling restraint did not last.

The number of rigs drilling for oil in the United States has already risen to 309, up from a low of just 172 last August, though it is still well below 678 at the same point last year.

Crucially, however, before the Texas ice storm, the rig count was rising on a similar trajectory to the increases after the last two slumps ending in 2009 and 2016.

This time could be different for US shale firms in terms of restraining production as prices rise. It could be different for OPEC+ in terms of adding extra barrels before the market overheats.

But the behaviour of both shale firms and OPEC+ is deeply entrenched and it would be unwise to bet against the cycle repeating itself.