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Can OPEC pull together?

Energy commodities are a key beneficiary as the major economies are being progressively reopened. But persistent discord within the Organization of the Petroleum Exporting Countries (OPEC) is preventing a coordinated expansion of production for now. At present, OPEC continues to maintain a supply deficit in the oil market. But are production increases on the cards in the foreseeable future?

Energy prices have rebounded in spectacular fashion with gains of around 40 per cent in the year to date. A barrel of Brent crude currently trades at around US$ 74. But dark clouds have recently appeared on the horizon. Firstly, the delta variant of COVID-19 is spreading rapidly, especially in Asia. This could slow down the economic recovery, especially in some emerging markets. And secondly, discord among members of the oil cartel recently thwarted efforts to reach agreement on an expansion of production. This is exacerbating the shortage of physical oil in the market and is likely to drive prices up in the near term. But the immediate effect was downward pressure on the oil price due to increased uncertainty arising from the internal turmoil at OPEC. Frictions within the cartel may prompt individual members to go it alone and increase their output, which could undermine the cartel’s pricing power. In this scenario, the credibility of OPEC, sometimes referred to as the ‘central bank of the oil market’, would suffer another blow that would depress the market’s medium-term outlook.

Massive bounce-back thanks to the reopening

OPEC generally aims to always stay one step behind the demand curve and has recently been taking a very disciplined approach, increasing production only very sporadically and thus successfully maintaining a supply deficit in the market.

Production up again, but capital investment is low

*Ratio of capital expenditure to depreciation (DJ Oil & Gas Titans 30)

US also faces supply bottlenecks in the medium term
Source: Bloomberg, as at 8 July 2021.

From a fundamental perspective, scarce supply is currently being met with growing demand. This is due to the robust economic recovery that is being driven by the reopening of major economies after renewed lockdowns to contain COVID-19 were imposed from the autumn of 2020. Supported in part by rapid progress with the rollout of vaccines, China was the first country to reopen, followed by the US and, most recently, Europe.

Oil driven up by economic optimism and physical shortages

Price of Brent crude in the year to date (US$)

US also faces supply bottlenecks in the medium term
Source: Bloomberg, as at 8 July 2021.

In terms of fundamentals, the price of oil should remain well supported in the medium term too. Union Investment’s experts anticipate that, after the initial recovery, the global economy should continue to grow at a healthy rate.

OPEC maintains deficit in the energy market

Nevertheless, there are three potential scenarios that could weigh on the oil price:

Firstly, the current price level of more than US$ 70 per barrel is high enough for all producers to extract oil at a profit. US shale oil producers are therefore now incentivised to ramp up their production again. This means that OPEC could be facing increased competition in the market. But it is unclear whether demand will continue to grow at a sufficient rate until 2022 to absorb the remaining capacity of OPEC and the additional US shale oil output.

Secondly, unofficial political pressure on OPEC, e.g. from major emerging economies such as India or China, could intensify if the oil price remains high due to extreme shortages. The aim of these countries would be to push for an expansion of production that would enable them to satisfy demand in their markets while avoiding energy price spikes and the associated inflation risk. This is perfectly achievable. OPEC currently has six million barrels of production headroom remaining that it could tap into.

Where will the tensions within OPEC lead?

However, the scenario that most recently put downward pressure on the oil price centres around the tensions within OPEC. At their meeting in early July, the member states failed to reach an agreement on higher production volumes. This means that their previous resolution – to keep output at the same level – remains in effect. This is likely to exacerbate the deficit in the market. The position of the United Arab Emirates is crucial in this context. The country has made substantial investments in the expansion of its production capacity, around 30 per cent of which currently remains unused. The UAE is therefore demanding higher production quotas and has rejected plans to fix the current quotas until the end of 2022 – putting itself at odds with Saudi Arabia. In addition, political relations between the two countries are also strained. Against this backdrop, no agreement was reached at the last meeting.

Despite the shortage of physical oil in the market, the price of oil dropped in response, due to uncertainty about OPEC’s ability to act going forward. Many financial investors have collected profits on their positions. However, the price drop may also act as a warning shot for OPEC that incentivises the members of the cartel to reconsider their position. An agreement on higher output levels in the coming weeks is conceivable. The decisive factor will be whether Saudi Arabia and the UAE can reach a compromise or whether the UAE breaks ranks. But given how closely the two countries are intertwined economically, the latter seems unlikely.

Production will go up

One way or another, the production volume of OPEC members is likely to go up in the coming weeks, either as a result of concerted action or because individual countries begin to ‘cheat’ and produce more than their allocated quotas. A formal agreement would support the oil price because it would reduce uncertainty in the market. As a result, the oil price could edge closer to the US$ 80 per barrel mark.

However, global economic growth is expected to slow down slightly after the steep initial rebound. Over the rest of the year, we thus see little to no further upside potential for the oil price.

 

As at 9 July 2021