This week is a big week for Oil. OPEC discussions are currently weighing up whether to increase production. It’s a toss up between supporting a still fragile global recovery or to keep prices supported and supply tight.
OPEC is still responsible for around 40% of the world’s oil production. Notwithstanding the cheating on quotas and the creeping rise of alternative energy sources, oil and OPEC remain central to the near and medium-term fate of the world’s economy.
Before we delve into the dynamics of black gold, some useless but interesting nuggets:
The country with the largest oil reserves on the planet – Nope, not Saudi Arabia… its Venezuela (yip the same Venezuela which regularly flirts with total economic ruin).
However, the prize for the world’s largest producer of crude oil goes to… and, nope, not Saudi Arabia… it’s the USA with other podium spots to Saudi and Russia.
This week, for the reader unfamiliar with some of the concepts in this space, I discuss the differences between global benchmarks and what they tell us. I also look at some of the fundamental drivers and end off with my near-term perspectives.
These blog posts are commentary. There is ALOT more beneath the surface.
For more detailed and in depth analysis of macroeconomic and markets drivers, and what they mean for your business and strategy, please reach out at firstname.lastname@example.org to explore our services.
A barrel by any other name
There are many types of crude. What you need to know is that Crude oil is… well, Crude. It needs to be refined to be turned into the types of fuel useful for energy generation, gasoline, etc. In crude terms, you prefer light to heavy, and you prefer sweet to sour. No, we’re not talking culinary preferences. The preferences highlighted here refer to the quality of the crude and its implied cost and difficulty to refine.
The 2 major global benchmarks are Brent and WTI. The former derives its price from the North Sea Brent oilfield (Shell and Exxon used to name their fields after birds, in this case the Brent Goose). The latter, a little less exciting, an acronym for West Texas Intermediate.
Historically, WTI traded at a premium to Brent because it is easier to refine. Brent usually serves as a more global benchmark while WTI serves as the benchmark price in the Americas.
Let’s look at the numbers
While Brent and WTI price generally track one another, divergences often reflect technical, supply/demand or geopolitical issues. For example, when there are heightened tensions in the Middle East, Brent prices tend to reflect a greater premium.
Similarly, as production in the US surged amid the shale oil boom around 2015, WTI prices slumped as supply/demand dynamics pressured regional benchmarks. Bearing these dynamics in mind, it is often useful to look at the Brent-WTI spread as an indicator for what some of the macro drivers are at any point in time.
From the 1980’s to around 2005, WTI traded either at parity or at a premium to Brent. Thereafter, and most notably, after the Global financial crisis, Brent seemed to take the lead. This was because of a number of factors. These included heightened tensions in the Middle East amid the Arab Spring movement as well as increased production from US crude sources which pressured WTI prices.
Since 2012 (around the time of the Eurozone debt crisis), the US economy has stepped into higher gear. On a relative basis this has seen the Brent premium steadily unravel as the US economy became a principal driver of global growth.
The chart above maps the dollar index against the Brent-WTI spread. Similarly, in the vein of the US being a driver, the dollar index is mapped to the left axis (inverted) and tends to correlate (i.e.: The higher WTI goes relative to Brent, the stronger the dollar).
Stepping on the Gas
Does a higher WTI price relative to Brent concur with the ‘on the ground’ realities of supply and demand. Lets have a quick look at some data. The world is dependent on oil for now. It has remained in a structural (or arguably an engineered) deficit.
The aforementioned OPEC meeting is always at pains to attempt to ‘balance’ the market. Unless geopolitical tensions are incentivizing otherwise (which has happened before), OPEC will act to ensure that supply meets demand in a manner which is not disruptive to pricing.
This supply demand dynamic maps quite well against overall crude prices in the long term. The chart excludes the pandemic related crash in crude. This crash also coincided with a move from Saudi Arabia to boost production around the same time as part of an implicit price war.
The pandemic as well as the concurrent slump in oil prices (remember that near term futures went negative!) resulted in massive upstream pressures and curtailed investment and drilling activity. The Rig count acts as a proxy and lead indicator for production.
From pre-pandemic levels, rig counts almost halved and have only recently started to tick up marginally. Over the same time period, the US economy’s voracious appetite for oil has kicked back into gear, with US crude imports rising as the economic rebuild commences.
Given the lack of investment over the last year, any movement in near term prices to ease the demand pressure will need to come from spare capacity and players like OPEC. This highlights the importance of watching this space.
What’s that mean?
On a technical basis, crude prices are now testing the 2009-2021 trend line. Momentum indicators appear overbought, and I would not be surprised to see some resistance and potentially downside pressure in the near term.
That said, given the fact that OPEC remains the key player capable of any large-scale supply boosts in the near term means that we remain at the whims of the cartel. That said, OPEC is often sensitive to not strangle the ‘golden goose’.
With near term inflation pressures building and threatening to unravel the global recovery, I would like to believe that OPEC has the willingness to boost supply just enough to ensure that the machinery of the global recovery remain…. Wait for it…. Well oiled.
The relationship between crude prices and CPI is a tight one regardless of which country you are. Pressures on oil importers, like South Africa, will be greater. The other dynamic is that the more oil exporters make, the greater the support for the US dollar and US yields. The global circular reference of the petrodollar is a discussion for another day.
Higher oil prices tend to be dollar supportive. Interestingly, however, in the case of the USDZAR, the relationship is a negative one. That is to say that as oil prices rise, the rand tends to strengthen. This is likely due to the relationship of the USDZAR with overall commodity prices. The relationship is a weaker one but one to watch.
In aggregate, I would look to see some additional supply from OPEC as nod to the fact that no-one wants to choke off a global recovery which is still vulnerable amidst a divergent pandemic response. Demand will likely remain supported as economies reopen and as global travel resumes. This will likely act as a counterbalance to any supply increases from OPEC.
As such, even if supply is increased and near-term prices ease off (I’m hoping for a move to the $50’s again), medium term prices may stay supported for a while longer barring any massive dislocations. If we see some price pressure, this will also allay inflation fears and could prove risk supportive. This is all why we hope OPEC does not Sp(oil) the party!
These blog posts are commentary. There is ALOT more beneath the surface.
For more detailed and in depth analysis of macroeconomic and markets drivers, and what they mean for your business and strategy, please reach out at email@example.com for a quote.