Easwaran Kanason

Co - founder of NrgEdge
Last Updated: July 8, 2021
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Business Trends
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A year ago, Brent crude prices were trading at some US$40/b. With the world then coming off the first wave of Covid-19 infections, this was seen to be a decent price for crude oil. Several waves later, Brent prices reached US$50/b in January 2021, with the beginnings of a global vaccination drive promising recovery. And what a recovery it has been. As we reach the half year point, Brent crude prices are now trading at US$75/b. That’s a 50% jump in over 6 months, one of the best performances for crude prices ever and the highest level in over 2 years. The question on everyone’s minds right now is: what’s in store for the second half of the year?

In pure market terms, crude prices are now reflecting the rapid recovery in global economic activity matched against output levels that are still curtailed. Led by rapid vaccination progress in the US, Europe and China – with the rest of the world slowly catching up – fuel demand has recovered to the point where market analysts have commented that the massive glut built up by the collapse in consumption in 2020 has been virtually eliminated. Even the beleaguered airline industry is back on its feet; regional travel within Europe has opened up again and American Airlines made the headlines last week for cancelling up to 15% of its daily flights…. not because of empty planes, but because it did not have enough staff to man those planes.

The acceleration in consumption recovery has some market observers predicting that crude oil prices could return to the prodigious US$100/b mark by the end of the year. And these are not just any market observers. This is the Bank of America, Goldman Sachs and the world’s second-largest independent oil trader Trafigura. The market, it is said, is hungry for oil. Even though demand has not yet fully recovered, it is far stronger than was predicted. But on the supply side, there is the continued supply quotas imposed by OPEC+ that is keeping prices high, as well as what Trafigura is calling ‘structural underinvestment in new production.’ By which he means that the shock of Covid has held back new upstream projects that could otherwise start producing now, which is also exacerbated by the furore around climate change that is scaring off investment by publicly-traded companies. And, unusually, the US shale patch has not responded to the strong price signals in the way they would previously. Where the mantra had been ‘drill, baby, drill’, US shale players are now practising unusual discipline, focusing on building shareholder value than chasing greater volumes and revenue. All of which means that crude supplies are unable to keep full pace with charged-up demand.

This is, of course, a recipe for OPEC+ to loosen its supply quotas. Following a nervous January, the OPEC+ club has been progressively allowing for higher output every month in 2021. This will continue when the group meets next to decide on its targets for August and beyond. Further relaxation of quotas is on the table – which will be cheered on by most club members, especially Russia, Kazakhstan, Iraq and Nigeria – but don’t expect quotas to be eliminated completely. Some form of supply control will be present well in 2022 at the very least. Because OPEC+ countries have an incentive to keep prices relatively high, to rebuild their battered fiscal budgets and recover from the Covid revenue disaster. The US$70-80/b sweet spot is just right to meet national budget requirements while also balancing consumption drivers. But any higher and demand destruction starts kicking in. Which, in combination with the climate change debate, could be a potent combination in demonising oil and gas even further. So, if the Bank of America is right that we are heading towards US$100/b oil, expect OPEC+ to start making concrete moves in the opposite direction to keep prices in an acceptable range.

The odd combination of discipline within OPEC+ and the US shale patch is having an interesting effect on prices. Specifically the Brent-WTI spread. At less than US$2/b, the spread is now at its narrowest in 8 months, and much lower than the US$4/b spread the last time oil prices were at this level. Why is this? Well, the spread is typically based on four factors – US crude production, US crude supply/demand balance, North Sea crude operations and geopolitical issues in international crude markets. The first and the last are of most interest right now. Since US onshore shale drillers aren’t rushing to restart rigs – only 470 rigs are currently operating in the US according to Baker Hughes – US crude production is more than 3 mmb/d off its pre-Covid peak. With US refineries now running at near-record utilisation rates to meet surging demand, refiners are bidding up US crude prices to secure domestic supplies rather than see them leave as exports. Which explains why the WTI is in a growing backwardation structure, where oil for prompt delivery is more expensive than futures contracts, because there is a demand for oil now.

On the flip side, OPEC+’s relative discipline has been instrumental is keeping prices high since any relaxation in supply quotas lags behind demand growth. But, crucially, there is also no geopolitical risk premium that is typically the main factor that blow out the Brent-WTI spread. Instead of an isolated Iran, world powers are now negotiating a return to the 2015 nuclear accord that could see Iran resume its status as a major crude exporter. The prospect of this has already kept Brent prices slightly subdued since May compared to WTI. Depending on how long the tightness in the US crude market lasts and how OPEC+ reacts with its supply relaxation programme, it is conceivable that WTI could close the gap with Brent even further. It could possibly even reach parity and exceed Brent – a situation that has only occurred a handful of times in the history of crude oil trading. We live in interesting times. The first half of 2021 was fascinating to observe as a crude market observer, being faster and brighter than anyone expected. The second half of 2021 could be similar. Let’s watch it play out.

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