Neither Iran nor Israel have rocked the oil vessel yesterday and the US and Europe, whilst keen on imposing fresh sanctions or expanding existing ones on Iran, were circumspect in not harming the Persian Gulf OPEC producer’s capability of exporting crude oil. The Ukrainian front, and may be this is a welcome turn of event, was uncharacteristically quiet, well, apart from the usual Russian sabre-rattling, after the $61 billion US aid package is on the verge of being signed by President Biden.

In the absence of any salient development in our segment of the market attention shifted to macro issues, to the stock markets and to the dollar and none of them disappointed. Global factory/business activity picked up in April with the notable exception of the US, but the world’s biggest economy currently falls into the “bad news is good news category”. Japanese manufacturing PMI rose to just under 50 last month, the German private sector finally expanded and business activity in the UK and in the eurozone grew at their fastest pace for nearly a year. Although the part segment of the economy slowed to a four-month low in the US, it has meant that the odds of a Fed rate cut have grown once again. The dollar weakened considerably, and global stocks rallied hard also aided by attractive US earnings, mixing a strong bullish cocktail, which, given the recent dip in oil, was too great a temptation to resist. As a result, both WTI and Brent jumped more than $1.40/bbl. The sentiment has conspicuously brightened. The optimism prevails this morning as the API reported a surprise draw in crude oil stocks but the underlying narrative remains one of pragmatism and caution.

The Dis-incentives to Taper Output Cuts

There is an abundance of reasons why a prolonged rally meaningfully over $95/bbl seems implausible in the current trading environment. These include the uninterrupted flow of oil from the Middle East amidst the crisis in which Iran now has been directly involved, stable and relentlessly growing production of crude oil outside the OPEC+ producer group, namely from the US, Canada, Brazil and Guyana, the forthcoming US elections, the perpetual anxiety amongst investors that bringing inflation down to the desired 2% target is a substantially more arduous undertaking than previously thought and the comfortable spare production capacity some OPEC members sit on, which can be utilized in case of a supply emergency. It is fair to conclude that the last two on the list played the most prominent roles in bringing the price of Brent down from $92/bbl less than two weeks ago to below $86/bbl on Monday.

The current precarious fundamental backdrop in oil is akin to chart reading. There are so many variables or factors that might have an impact on the oil balance that it is as easy and justified to point to a bullish outcome at any given time as the other way round. It is one thing that, as outlined above, the upside seems limited to a few dollars over the $90 level, but if that is a vindicated view how far could prices fall? In other words, at what level would the bullish elements of the equation would kick in and what are these elements?

To begin with, there are two wars happening concurrently in major oil producing regions, which are good enough reasons not to expect a retreat very much below $80/bbl. Secondly, financial investors could be inclined to use oil as a hedge against inflation. (Funny, how inflation can be viewed and used as a useful tool by both bulls and bears.) Finally, the current oil balance as seen by salient forecasters shows supply deficit for this year, albeit the extent of it is the subject of heated debate. This shortfall is partly or even chiefly the function of the market management policy of OPEC and its 10 allies. The group has reduced its cumulative output by well over 5 mbpd since 4Q 2022. During this period, or from the lows in 1Q 2023, to be more accurate, the price of Brent has risen by almost 40% from bottom to top, an explicit nod to the influence OPEC+ asserts over the market.

The price of oil received an undeniable boost from the combination of coordinated and voluntary production cuts but the same cannot be said about OPEC revenues. The group’s daily in-take from petrodollars was $2.67 billion in October 2022 with output at 28.51 mbpd (without Angola) and the monthly average OPEC basket price at $93.62/bbl. Last month an output level of 26.61 mbpd was coupled with a basket price $84.22/bbl resulting in an income of $2.24 billion. The major beneficiaries of the disciplined supply pact have been those outside of it.

Which leads us to the relevant question of whether these output constraints would and should be lifted gradually or abruptly at any time in the foreseeable future. As Energy Intelligence points out there will be several factors under consideration when the talks about reversing the strategy get under way, possibly at the next ministerial meeting on June 1. One of the key drivers of the negotiations will be demand, which OPEC is irrevocably sanguine about, closely followed by healthy non-OPEC+ supply, geopolitics, and macroeconomic considerations. The current and expected price level will also play an important role in deciding how to proceed in the second half of the year.

In fact, it could be as important as demand expectations if not more. The IMF estimates that the de facto leader of the alliance, Saudi Arabia, will need an average oil price of $96.20/bbl at a production rate of 9.3 mbpd in 2024 to balance its budget. Less than a year ago this price was deemed to be $80.90/bbl. It will decline to $84.70/bbl should the Kingdom add back 1 mbpd of production. An additional 1 mbpd of Saudi production then can be extrapolated to an increase of 2.2 mbpd from the OEPC+ group. Whilst the current oil balance presented by OPEC might be able to absorb such an increase the IEA and possibly market players would respectfully disagree, and an increase of this magnitude would lead to a change of view from supply deficit to surplus and thus to a material drop in oil prices. In turn, the amended perspective would dis-incentivize the producer group to return these barrels to the market unless oil is expected to scale fresh annual peaks and stay there, which is improbable under the current circumstances. And if this is, in fact, the case a price band of around $85-$95/bbl has been established.

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