The spread between the world’s two benchmark crude oil markers – Brent and WTI – is currently hovering at US$6/b. This is the widest gap between the two for a long while, first breaching the tight US$2/b spread range since 2015 in the run up to Hurricane Harvey as traders fretted that widespread refinery closures along the US Gulf would impact US crude consumption.
Those refineries have come back online, but the spread is still persisting. It is so large that India’s Reliance – an opportunistic buyer if there was any – bought a massive million barrel cargo of US crude oil last week. All across Asia, key buyers are taking advantage of this new arbitrage window to stock up on (cheaper) American crude, some for the very first time. Indian refiners – notably state refiners IndianOil, HPCL and BPCL – are leading the way, with buyers from South Korea, Japan, Thailand and Singapore also in the fray. Chinese activity is still minor, but one has to imagine they can’t be that far behind.
When the Brent-WTI spread hit its all time high at US$28/b in September 2011, there was a similar enthusiasm for US crude. Volumes then, however, weren’t readily available. The WTI discount to Brent then was because oil generated from the burgeoning US shale revolution was trapped in Cushing, Oklahoma – the main price settling point for WTI – at a time when global demand was soaring. In other words, the discount was due to the inability of sufficient WTI volumes to make it into the wider market. The oil was there, but midstream infrastructure to ship it to Houston and from there to the wider world, was inadequate. A rush to expand existing pipelines and build new ones – transportation by train was even used at one point to clear volumes – occurred, and when it did by 2014, the Brent-WTI spread had decreased. The lifting of the US crude export ban in 2015 narrowed things even further, to a range of US$2-3/b.
In 2017, that lack of infrastructure is no longer there. Supply has caught up with the ability to meet demand, and as US oil exports soared, WTI prices have closed the gap with Brent, which is used as the main international marker, including Middle Eastern grades. In such a competitive scenario, we would expect both benchmarks to move towards parity.
But even before Hurricane Harvey reared its head, the Brent-WTI spread was already growing. The circumstances this time are different. On the Brent side, there is a ‘fear premium’ being priced in; tensions in the Middle East – between Qatar and the rest of GCC, tensions between Iraq and its Kurdish province – have been raising the spectre of supply disruptions. More significant though is that on the WTI side, there is now once again an abundance of supply. But unlike before, that supply can make it to market. Which is why we are seeing such strong volumes of US crude exports. Some six million barrels are earmarked to be shipped from the US to Asia for November so far; up from usual monthly shipments of 2-3 million barrels. The cheap prices are enticing, but Asian refiners are being forced to look further afield for crude as OPEC and some non-OPEC sellers have been cutting availability as part of their supply freeze.
US crude exports reached an all-time weekly high at the end of September. That jump in demand should naturally reduce the spread. The Brent physical market is tight, meaning that Brent’s strength is not artificial but demand driven. A break towards US$60/b appears possible soon. But a look over the future curve indicates that the current Brent-WTI spread will persist through October 2018, having doubled since May 2017. This suggests that the sheer amount of supply coming out of the US will negate demand drivers to keep WTI significantly lower than Brent, where supply is a lot steadier.
That’s good news for Asian buyers, as the avenue of cheaper US crude remains open to them for far longer. With OPEC likely to extend, or even deepen, the supply freeze beyond the current deadline of March 2018, Brent-linked crude volumes will be in short supply. The distance from Houston to Yokohama, Singapore or even Paradip is vast - VLCCs have to go through the Suez as the Panama Canal is too narrow – but at current and projected spreads, well worth the distance.
Something interesting to share?
Join NrgEdge and create your own NrgBuzz today
Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO)
In its January 2020 Short-Term Energy Outlook (STEO), the U.S. Energy Information Administration (EIA) forecasts that annual U.S. crude oil production will average 11.1 million b/d in 2021, down 0.2 million b/d from 2020 as result of a decline in drilling activity related to low oil prices. A production decline in 2021 would mark the second consecutive year of production declines. Responses to the COVID-19 pandemic led to supply and demand disruptions. EIA expects crude oil production to increase in 2022 by 0.4 million b/d because of increased drilling as prices remain at or near $50 per barrel (b).
The United States set annual natural gas production records in 2018 and 2019, largely because of increased drilling in shale and tight oil formations. The increase in production led to higher volumes of natural gas in storage and a decrease in natural gas prices. In 2020, marketed natural gas production fell by 2% from 2019 levels amid responses to COVID-19. EIA estimates that annual U.S. marketed natural gas production will decline another 2% to average 95.9 billion cubic feet per day (Bcf/d) in 2021. The fall in production will reverse in 2022, when EIA estimates that natural gas production will rise by 2% to 97.6 Bcf/d.
Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO)
EIA’s forecast for crude oil production is separated into three regions: the Lower 48 states excluding the Federal Gulf of Mexico (GOM) (81% of 2019 crude oil production), the GOM (15%), and Alaska (4%). EIA expects crude oil production in the U.S. Lower 48 states to decline through the first quarter of 2021 and then increase through the rest of the forecast period. As more new wells come online later in 2021, new well production will exceed the decline in legacy wells, driving the increase in overall crude oil production after the first quarter of 2021.
Associated natural gas production from oil-directed wells in the Permian Basin will fall because of lower West Texas Intermediate crude oil prices and reduced drilling activity in the first quarter of 2021. Natural gas production from dry regions such as Appalachia depends on the Henry Hub price. EIA forecasts the Henry Hub price will increase from $2.00 per million British thermal units (MMBtu) in 2020 to $3.01/MMBtu in 2021 and to $3.27/MMBtu in 2022, which will likely prompt an increase in Appalachia's natural gas production. However, natural gas production in Appalachia may be limited by pipeline constraints in 2021 if the Mountain Valley Pipeline (MVP) is delayed. The MVP is scheduled to enter service in late 2021, delivering natural gas from producing regions in northwestern West Virginia to southern Virginia. Natural gas takeaway capacity in the region is quickly filling up since the Atlantic Coast Pipeline was canceled in mid-2020.
Just when it seems that the drama of early December, when the nations of the OPEC+ club squabbled over how to implement and ease their collective supply quotas in 2021, would be repeated, a concession came from the most unlikely quarter of all. Saudi Arabia. OPEC’s swing producer and, especially in recent times, vocal judge, announced that it would voluntarily slash 1 million barrels per day of supply. The move took the oil markets by surprise, sending crude prices soaring but was also very unusual in that it was not even necessary at all.
After a day’s extension to the negotiations, the OPEC+ club had actually already agreed on the path forward for their supply deal through the remainder of Q1 2021. The nations of OPEC+ agreed to ease their overall supply quotas by 75,000 b/d in February and 120,000 b/d in March, bringing the total easing over three months to 695,000 b/d after the UAE spearheaded a revised increase of 500,000 b/d for January. The increases are actually very narrow ones; there were no adjustments for quotas for all OPEC+ members with the exception of Russia and Kazakshtan, who will be able to pump 195,000 additional barrels per day between them. That the increases for February and March were not higher or wider is a reflection of reality: despite Covid-19 vaccinations being rolled out globally, a new and more infectious variant of the coronavirus has started spreading across the world. In fact, there may even be at least of these mutations currently spreading, throwing into question the efficacy of vaccines and triggering new lockdowns. The original schedule of the April 2020 supply deal would have seen OPEC+ adding 2 million b/d of production from January 2021 onwards; the new tranches are far more measured and cognisant of the challenging market.
Then Saudi Arabia decides to shock the market by declaring that the Kingdom would slash an additional million barrels of crude supply above its current quota over February and March post-OPEC+ announcement. Which means that while countries such as Russia, the UAE and Nigeria are working to incrementally increase output, Saudi Arabia is actually subsidising those planned increases by making a massive additional voluntary cut. For a member that threw its weight around last year by unleashing taps to trigger a crude price war with Russia and has been emphasising the need for strict compliant by all members before allowing any collective increases to take place, this is uncharacteristic. Saudi Arabia may be OPEC’s swing producer, but it is certainly not that benevolent. Not least because it is expected to record a massive US$79 billion budget deficit for 2020 as low crude prices eat into the Kingdom’s finances.
So, why is Saudi Arabia doing this?
The last time the Saudis did this was in July 2020, when the severity of the Covid-19 pandemic was at devastating levels and crude prices needed some additional propping up. It succeeded. In January 2021, however, global crude prices are already at the US$50/b level and the market had already cheered the resolution of OPEC+’s positions for the next two months. There was no real urgent need to make voluntary cuts, especially since no other OPEC member would suit especially not the UAE with whom there has been a falling out.
The likeliest reason is leadership. Having failed to convince the rest of the OPEC+ gang to avoid any easing of quotas, Saudi Arabia could be wanting to prove its position by providing a measure of supply security at a time of major price sensitivity due to the Covid-19 resurgence. It will also provide some political ammunition for future negotiations when the group meets in March to decide plans for Q2 2021, turning this magnanimous move into an implicit threat. It could also be the case that Saudi Arabia is planning to pair its voluntary cut with field maintenance works, which would be a nice parallel to the usual refinery maintenance season in Asia where crude demand typically falls by 10-20% as units shut for routine inspections.
It could also be a projection of soft power. After isolating Qatar physically and economically since 2017 over accusations of terrorism support and proximity to Iran, four Middle Eastern states – Saudi Arabia, Bahrain, the UAE and Egypt – have agreed to restore and normalise ties with the peninsula. While acknowledging that a ‘trust deficit’ still remained, the accord avoids the awkward workarounds put in place to deal with the boycott and provides for road for cooperation ahead of a change on guard in the White House. Perhaps Qatar is even thinking of re-joining OPEC? As Saudi Arabia flexes its geopolitical muscle, it does need to pick its battles and re-assert its position. Showcasing political leadership as the world’s crude swing producer is as good a way of demonstrating that as any, even if it is planning to claim dues in the future.
It worked. It has successfully changed the market narrative from inter-OPEC+ squabbling to a more stabilised crude market. Saudi Arabia’s patience in prolonging this benevolent role is unknown, but for now, it has achieved what it wanted to achieve: return visibility to the Kingdom as the global oil leader, and having crude oil prices rise by nearly 10%.