OPEC+ Faces Moment of Truth on Planned Output Increase: Kemp

In the next few weeks, Saudi Arabia and its OPEC+ allies must take a delicate decision about whether to proceed with planned production increases from October, or postpone them because of an uncertain economic outlook.

The recent slides in front-month Brent futures prices, calendar spreads and refinery margins, amid concerns about the outlook for petroleum consumption, have dramatized the danger of getting it wrong.

Boosting production despite downward revisions to consumption growth and a continued output increases from rivals in the United States, Canada, Brazil and Guyana risks another accumulation of inventories and slump in prices.

But postponing risks conceding even more market share to western hemisphere rivals and tempting some OPEC+ members to break ranks and increase output unilaterally.

PLANNED OUTPUT

Saudi Arabia and other OPEC+ members are enforcing three separate tranches of production cuts put in place since late 2022 to drain excess petroleum inventories and support prices.

All OPEC+ members are supposed to be participating in an official collective cut of 2 million barrels per day (b/d) agreed in October 2022 at a time of uncertainty about the economic and oil market outlook.

In addition, some members are meant to be enforcing an additional voluntary cut of 1.66 million b/d agreed in April 2023 and another voluntary cut of 2.2 million b/d agreed in November 2023 to support market stability.

In June 2024, ministers agreed to unwind the last of these voluntary cuts gradually - beginning in October 2024 and finishing by September 2025.

They also agreed to permit the United Arab Emirates to increase its output progressively by an extra 300,000 b/d - starting in January 2025 and also finishing by September 2025.

Under this plan, total OPEC+ production is scheduled to increase by roughly 180,000 b/d each month in the fourth quarter of 2024 and then by 210,000 b/d each month in the first nine months of 2025.

From the beginning, however, ministers emphasized the scheduled production increases were conditional and could be "paused or reversed subject to market conditions".

In the next few weeks, OPEC+ must decide whether to proceed, or modify or postpone these increases in the light of renewed concerns about the health of the global economy and oil demand.

PRICES AND SPREADS

Oil prices and spreads are currently about the same or weaker than they were when ministers agreed to the second set of voluntary cuts in November 2023.

Inflation-adjusted front-month Brent futures have averaged US$79 per barrel so far in August 2024 (42nd percentile for all months since 2000) down from US$84 in November 2023 (49th percentile).

Brent's six-month calendar spread has traded in an average backwardation of US$2.50 this month (73rd percentile) somewhat stronger than US$1.63 in November (57th percentile).

But inflation-adjusted refinery margins for making two barrels of gasoline and one barrel of distillate from U.S. crude have been US$22 this month (43rd percentile) down from US$24 in November (50th percentile).

With the exception of calendar spreads, which are moderately bullish, other price indicators are consistent with a rough balance between production and consumption at the moment.

Every one of these indicators has weakened materially since ministers made the provisional decision to increase production in June 2024.

GLOBAL INVENTORIES

Commercial stocks of crude and refined products in the advanced economies belonging to the Organization for Economic Cooperation and Development amounted to 2,761 million barrels at the end of June.

Stocks were 120 million barrels (-4% or -0.71 standard deviations) below the ten-year seasonal average and the deficit had almost doubled from 66 million (-2% or -0.44 standard deviations) in November 2023.

The deficit was the widest for almost two years since September 2022, according to data from the U.S. Energy Information Administration (EIA).

Chartbook: OPEC+ output decision

Since late June, U.S. commercial crude inventories have continued to decline further and faster than usual, adding to evidence of a tightening market.

U.S. crude inventories declined in seven of the eight weeks since June 21 by a total of 35 million barrels, according to the EIA.

U.S. crude inventories typically decline over July and August as refineries ramp up processing to meet elevated demand for gasoline during the summer vacation period.

But the seasonal depletion this year was the second-largest in the last decade after 2017, indicating global supplies likely continued to tighten at the start of the third quarter.

U.S. crude inventories were 9 million barrels (-2%) below the ten-year average on Aug. 16 down from a surplus 6 million barrels (+1%) on June 21.

Most of the depletion occurred at refineries and tank farms in Texas and Louisiana along the Gulf of Mexico, the most closely integrated with global oil markets.

Gulf Coast crude inventories declined in seven of the last eight weeks by a total of 25 million barrels, compared with an average depletion of 10 million over the previous decade.

TACTICAL CONSIDERATIONS

By early August, portfolio investors had cut their combined position in crude and fuels to some of the lowest levels since 2013.

Hedge funds and other money managers held a combined position in the six most important futures and options contracts equivalent to just 226 million barrels (3rd percentile for all weeks since 2010) on Aug. 13.

The position was down from a recent high of 524 million barrels (40th percentile) at the start of July and 338 million barrels (14th percentile) in November 2023.

In recent weeks, fund managers have reduced their positions in response to increased uncertainty about the outlook for the major economies and global oil consumption.

It is unclear to what extent they have also reduced positions in anticipation OPEC+ would proceed with scheduled output increases, and therefore how much of the increase if any is already discounted in prices.

If the scheduled increase has been fully discounted, deferring some or all of it could spark a sharp rally in prices, accelerated and amplified as fund managers try to rebuild positions.

If it has not been discounted at all, proceeding risks sparking an even deeper fall in prices as funds sell more contracts.

STRATEGIC CHOICES

Looming over all these tactical considerations is the outlook for the global economy in the rest of 2024 and in 2025.

Global manufacturing and freight activity has flat-lined or weakened since April, which has resulted in petroleum consumption growing much more slowly than seemed likely at the start of the year.

In response to economic softening, it seems likely the U.S. Federal Reserve and other central banks will trim interest rates to stimulate consumer and business spending.

OPEC+ must decide whether to focus on the current softness (which favors a postponement) or the stimulus and anticipated recovery (which could lead to faster oil consumption and favor pressing ahead).

The most cautious approach would be to wait for the economy to accelerate and a rise in oil prices before proceeding, delaying some or all of them for a few months.

If the group is more confident in the economic and consumption outlook, it might go ahead anyway, daring to prove the hedge fund sceptics wrong.