By John Kemp
LONDON: Saudi Arabia’s oil minister has called for a cautious approach to raising production, even as prices surge and many traders anticipate an increasingly severe shortage of petroleum later this year.
“We are in a much better place than we were a year ago, but I must warn, once again, against complacency. The uncertainty is very high, and we have to be extremely cautious,” the minister said in a speech on Wednesday.
In contrast, futures markets point to a rapid tightening of supply, with front-month Brent up more than $25 per barrel or 65% in just over three months since successful vaccine trials were announced in early November.
Brent’s six-month calendar spread has surged into a backwardation of more than $3.70 per barrel, putting it in the 94th percentile for all trading days since 1990, and indicating traders expect a rapid depletion in oil stocks.
The spread was this strong for brief periods during 2019 and in the first few weeks in 2020, flashing expected tightness, but the last time it was this tight on a sustained basis was in 2013.
OPEC+ AND TRADERS
Disagreements between the Saudi oil minister and traders about the forecast balance between production and consumption historically have been common at this point in the price cycle.
Saudi Arabia and other producers in the Organization of the Petroleum Exporting Countries, as well as the broader group of allies led by Russia (OPEC+), tend to be over-pessimistic about consumption early in the upswing.
Part of the reason is fear of a return to low prices and revenues when memories of the recent slump are still fresh. “The scars from the events of last year should teach us caution,” as the Saudi minister said on Feb. 17.
But producers also have a financial incentive to err on the side of caution. Under-forecasting consumption and over-forecasting production leads to a rise in prices and revenue windfall.
“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,” Saudi Arabia’s previous oil minister said almost exactly three years ago in February 2018, when prices and spreads were at the same level they are now.
Rising prices are beneficial for government finances in the short term, even if they create the conditions for over-production and another slump in the long term.
The result is that it is quite normal for OPEC to be wary of raising output at this stage in the cycle – even as prices rise, inventories shrink and the market moves into a pronounced backwardation.
OPEC’s slowness in raising production typically causes inventories to fall below average, and prices to overshoot on the upside, until a rise in output from non-OPEC producers causes prices to peak and then start to fall.
Speaking this week, the Saudi oil minister had a warning for any traders or analysts trying to guess how OPEC+ will respond to the recent rise in prices:
“On the subject of predictability, this also applies to those who are trying to predict the next move of OPEC+. To those I say – don’t try to predict the unpredictable.”
In fact, the outline of the price cycle and OPEC+ responses to it are both broadly predictable, in the sense that they follow a regular pattern of moves.
Every price cycle is slightly different. Some slumps are triggered by recessions, others by volume wars. And OPEC+ ministers come and go. But the basic decision-making framework and incentives stay largely the same.
The precise timing and magnitude of peaks and troughs cannot be forecast because the market is a complex adaptive system that has some chaotic features.
But the broad pattern of rising and falling prices, production, consumption, inventories and spreads, as well as OPEC’s response to them, follows a familiar sequence.
The cycle can be split into a series of phases. The exact number is somewhat arbitrary and the phases can overlap and not be fully distinct .
The attached chart book shows both a basic 4-phase and a more elaborate 6-phase version, but it can be split into even more phases if necessary.
The recent fall in inventories, rise in spot prices, and shift towards a steep backwardation, indicate the market is moving towards a peak (Phase II in the six-phase version of the cycle) or peaking (Phase III).
In previous cycles, at this point OPEC’s resolution to continue restricting output would weaken (Phase II) and it would come under pressure to curb price increases by boosting production (Phase III).
The current upswing appears to be following the same pattern. In late 2020 and early 2021, several members of OPEC+ pushed for output increases and compliance appears to be fading for many members.
With prices surging, the organisation already faces increasing calls to start boosting output or risk a resurgence of drilling and production from U.S. shale firms.
With inventories shrinking rapidly, the speed with which OPEC moves from Phase II to Phase III is likely to determine the eventual timing and scale of the overshoot – as well as the timing and depth of the subsequent slump.