The International Energy Agency (IEA) announced yesterday (March 1) that it would release 60 million barrels of oil reserves in a bid to stymie the relentless rally in oil prices following Russia’s invasion of Ukraine.
"At face value, whilst welcome, the magnitude is insufficient. The response is limited as we believe it only represents an only ~1 month offset to the prospects of around a one-third (~2m b/d) loss of Russia’s 6m b/d oil exports," says a MUEF Global Markets Research report.
The current “self-sanctioning” of Russian oil (and broader commodities), with buyers and shippers skittish to move Russian barrels despite energy carve-outs in sanctions (be it for uncertainty about precisely what’s legally permissible, concerns surrounding reputational repercussions or merely for moral objections) is creating a large production distortion in global oil markets, it says.
The immediate rally in oil prices is a testament that markets are already looking through the announcement and remain squarely focused on the extreme state of shortage oil markets are in today corroborated by the super backwardation levels with Brent crude prompt timespreads currently trading ~USD5/b above the next month – an unprecedented level that indicates trades are paying huge premiums to secure more immediate supply, the study pointed out.
Furthermore, it is critical to state that the since the last ~80 million barrel coordinated SPR release in November 2021, strategic reserves have in fact only fallen by 27 million barrels. Thus, the initial tranche would have to be absorbed before the second tranche hits global markets.
In short, 60 million barrels is far below what levels that could jolt today’s supply constrained market. As a one-off crude release, it is dwarfed by the extraordinary magnitude of Russia’s export disruptions. The market’s critically depleted inventories and thinning spare capacity levels in the face of a record long unresolved deficit ultimately leaves one lever to rebalance oil markets – demand destruction.
"This has been our central premise we advocated in early February as the mechanism that can slowdown demand growth so that the physical flow of oil can balance. That is the cure for high oil prices is higher oil prices – a self-correcting process.
All eyes will be on Opec+ when it meets today (March 2) to discuss its output levels for April crude deliveries. There is intense pressure on the group to increase output more aggressively given the unprecedented geopolitical tensions and a powerful bullish price environment.
The consistent rhetoric in recent days, which has been reinforced by the group’s Joint Technical Committee (JTC) on March 1, suggests that Opec+ will stick to increasing output by 0.4m b/d. This is premised on their current assessment that the current high price environment is being driven by the paper oil market taking a precipitous level of long positions to reflect geopolitical risks – rather than physical supply and demand imbalances.
With this, anything more than 0.4m b/d would be a surprise to the market which could led to a knee-jerk bearish move lower. Though such potential weakness will ultimately prove short-lived given the relentless forces keeping oil prices elevated anchored on the simultaneous blend of depleting inventories and thinning spare capacity amid a dearth of structural underinvestments.
"Of more concern has been the group’s struggle to keep pace with its 0.4m b/d monthly increase in target. The latest data from the group signalled that they were collectively increasing output by ~0.28m b/d – that has not changed much in the past six months. Even if Opec+ does find a way – predominantly through the few countries where spare capacity exists – namely Saudi Arabia, the UAE and Iraq – to actually pump closer to their collective output target, that raises its own challenges.
With most Opec+ members already pumping at maximum levels, the cushion of spare capacity even amongst these three countries is shrinking – this tapering of shock absorbers will rattle investors in the months ahead, in our view," the report said.
Thinning spare capacity is increasingly nerving markets
"As we recently catalogued, our bottom up country-by-country modelling analysis points to spare capacity falling to distressingly thin levels by this summer – below 2m b/d by July 2022 and remaining below this level throughout H2 2022. This has historically been a threshold wherein a small temporary supply disruption, caused by a geopolitical or weather related event, would cause acute price spike
risks to the upside. This has historical precedence. In 2004, the exhaustion of spare capacity triggered a significant rally in long-dated crude oil prices from $25/b to $65/b. At the time, the surge in long-dated prices created demand weakness that allowed inventories to build, creating a precautionary inventory cushion to buffer the oil market from a lack of spare capacity. We could very well witness a similar dynamic playout in oil markets this year. In short, capacity matters much more than Opec+ baselines at the current juncture, and it looks to get more scarce," it said.
Opec+ optimisation is for backwardation and has been successful
Beyond spot prices, the supply tightness in oil markets is being shown up in futures markets wherein prompt timespreads – which are one of the best indicators of market tightness given they price fundamentals and not expectations – corroborate with this market tightening. They remain in super backwardation – which are bullish structures where near-dated contracts trade at a premium to later-dated ones (signalling acute market tightness). This strikes at the heart of the Opec+ optimisation strategy in achieving fiscal stability through higher revenues and market share. In essence, backwardation favours Opec+ as it eliminates the financial incentive to store oil over time and discourages US shale producers from locking-in prices for future production (as low “deferred” prices through the backwardation structure can restrain higher cost producer’s ability to secure future cash flows and attract funding).
Furthermore, backwardation maximises low cost producers’ (namely, Opec+) revenues relative to higher cost producers (such as shale) that hedge, as they instead sell higher production levels at spot prices. "Key to this view is our belief that backwardation can rationalise shale growth by reducing returns expectations and increasing leverage expectations, both of which drive funding costs higher and slow capital allocation," the report says.
Uber-bullish oil price forecasts being played out
"The sheer dizzying of the oil price strength in recent weeks has even surpassed our above consensus bullish thesis anchored on the narrative that oil prices have ecome so disconnected from the marginal cost of supply that they are marching to the level where demand erosion becomes prevalent. We estimate this at $100-115/b and hold conviction that oil can rise up and register inside these
levels consistently for the coming quarters ahead.
"This is anchored on the narrative that when the simultaneous deficit of depleting inventories, thinning spare capacity and structural underinvestments blends towards extremely distressed levels – as continually corroborated by futures in acute backwardation (signalling market tightness) – then demand growth needs to slowdown so the physical flow of oil can balance. This in effect is carving out a “scarcity premium.'," it said.
It is important to state that this narrative has little to do with the geopolitics of the day, which is merely turbocharging the severe supply story. Such is the state of severe depletion in oil markets today, that the system is highly susceptive to even the smallest shocks – precisely what we are witnessing in Russia-Ukraine crisis today with markets increasingly pricing in losing Russian oil supply outright. Whilst it is not in either sides interest to use oil (and broader commodities) as a tool, the market is
having to price in the consequences of even an unlikely and mild disruption with large asymmetric upside price moves – such is the extreme shortage state of oil markets today. Succinctly put, geopolitical risks are on the rise in an oil system with no slack.
"With this context in mind, we reiterate that seldom has the strategic case for being long oil been this strong and we remain highly convicted that the price appreciation potential is substantial in 2022 as well as for the first half of 2023. With this our Brent average forecasts point to an average of $96/b in 2022 and $112/b in 2023," said the report.
"We envisage demand destruction through a slowdown in the global economy being realised by next summer with Brent peaking at $121/b – thereafter we see a correction to the downside in H2 2023 as markets begin to rebalance themselves to a more normalised equilibrium."
In the immediate term, the only potential short-term supply response would need to come from Opec+, as a surge in Saudi Arabian, Emirati and Iraqi production as well as a potential easing in Iranian crude sanctions leading to ~2m b/d increase in supply by the summer, with the 60m barrels in coordinated global SPR release helping bridge the gap. While such an manoeuvre becomes increasingly likely, the more Russia is shunned from the global economy, driving core-Opec+ (Saudi Arabia and the UAE), Iran and the West closer together, it would nevertheless come at the expense of a complete depletion of the global oil market’s spare capacity – still meriting much higher oil prices. We are not at maximum pain yet, says the report. -TradeArabia News Service