Will OPEC cool the oil market?



OPEC meets on Thursday and the outcome could decide the fate of oil prices, which have gone through the roof lately. The question is whether the cartel will sit back and enjoy the increased revenue or whether it will add more production to cool prices. Even if they do open the supply taps, the output boost will likely be minor, keeping any losses in oil prices limited. The real risk is production from Iran coming back online. 

Supply squeeze

What a rollercoaster ride this crisis has been for energy markets. Last year, oil prices turned negative as demand got decimated by lockdowns and the world was flooded in supply. Fast forward to today and oil is trading at multi-year highs, turbocharged by a powerful comeback in demand that has not been matched by an equal rebound in supply. 

Much of this shortfall boils down to chronic under-investment in the oil and gas industry. When you tell oil companies that their products must be replaced by green alternatives soon, why would anyone keep investing in carbon exploration and drilling? Those projects take years to deliver profits, so energy firms prefer to increase share buybacks rather than throw money on capital expenditures. 

Another force behind this incredible rally has been OPEC itself. The cartel and its allies slashed production last year to counter the collapse in demand and have been extremely cautious in bringing back supply. The current deal is for 400k barrels to come back each month until the cuts have been completely phased out. 

But with global energy prices going ballistic, several nations including the United States are pressuring OPEC to expedite those plans.  

Sweet spot

That said, OPEC doesn’t really want to play ball. The de facto leaders of this alliance - Saudi Arabia and Russia - have both expressed concerns about the demand outlook. They argue that the crisis isn’t over and that pumping too much now would risk flooding the market next year. 

This view has been echoed by several key players. The International Energy Agency, the US Energy Information Administration, and OPEC itself all forecast the oil market to swing into a supply surplus next year. With everyone fearing another round of oversupply soon, no wonder OPEC doesn’t want to step up. 

Indeed, this is the sweet spot for OPEC producers. Oil prices have risen to the point where their governments can fix the holes in their budgets, but not enough to invite higher-cost producers like US shale back into the game and risk losing market share. It’s the best of all worlds, so why spoil it? 

Bearing this in mind, if there is an acceleration in production this week, it will probably be minimal. Just enough to deflect the political pressure, but not enough to truly torpedo prices. Therefore, the risks surrounding oil this week seem tilted to the upside. Prices could jump if OPEC does nothing at all, while any retreat in case they add some symbolic supply may be relatively minor. 

Big picture

Having said that, the overall outlook for oil prices seems increasingly neutral. The market has already staged a stunning rally and extrapolating any massive gains from here is a bridge too far considering that the American government will actively fight that. 

There are several levers the White House can pull. The easiest one would be to strike a deal with Iran and relax the sanctions that have crippled its oil exports. Those talks are expected to resume this month. It’s a process that takes time, but if markets sense there’s a real chance this can get done, the signal alone could be enough to cool prices. 

Another way would be using the Strategic Petroleum Reserve, which holds a tremendous supply of crude oil for emergencies exactly like this one. That’s an immediate solution that can buy some time until the market stabilizes. A better solution would be for US shale producers to boost production, but the industry is fearful this price spike won’t last long, hence why active rigs remain so low. 

Derivatives markets agree that prices are likely to retreat over time. WTI futures are in steep backwardation, which means longer-dated contracts are trading at a lower price than near-term contracts. Longer-dated contracts are normally more expensive to reflect storage costs. Forward prices are also pointing lower over the next few years. 

Beyond oil

Finally, the path of oil prices will also affect the currencies of major oil-producing nations like Canada, Norway, and Russia. More importantly, it could be crucial for how quickly central banks tighten monetary policy, as there is a tight correlation between oil prices and market-based inflation expectations. 

Soaring inflation expectations have been a huge factor behind the latest move towards raising interest rates globally, so if oil prices take a step back, that would lessen the pressure on central banks to respond with force in their battle with inflation. Of course, that would be music to the ears of stock markets. 

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