Oil on Settled Waters: OPEC+ anticipates supply-demand imbalances

If you wanted one health metric for the global economy over the past decade, oil consumption is a good candidate. Consumption rose more than 14% from 2009 to 97.2 million barrels per day last year, in line with the world’s economic growth. The International Energy Agency forecasts that demand will reach 100 million bpd in 2019.

That trend underlines the solidity of the recovery since the financial crisis, and suggests that the challenge for oil is all about supply. With oil in storage compared with demand at the lowest levels since January 2015, and below a five-year average, the US, China and India have all called for higher supplies to avoid economically damaging shortages.

OPEC plus Russia last week secured an agreement to raise supply by as much as 1 million bpd, effective 1 July. The deal overcame resistance from Iran, OPEC’s third-biggest producer, which faces falling output as re-imposed US sanctions loom.

Avoiding shortages

The Organisation of the Petroleum Exporting Countries, which together with Russia accounts for nearly one-half of the world’s oil supply, implemented a production cut of 1.8 million bpd in January 2017. That cut addressed excess oil supplies that depressed oil inventories in 2015/2016. Since then, strong demand, production cuts and geopolitical tensions have helped push prices close to three-and-a-half-year highs.

The world’s big powers – the US, China and India – have lately put a reasonable amount of pressure on OPEC to reach an agreement, notably through the establishment on 11 June of an “oil buyers’ club” by China and India, which seeks to facilitate more US crude inflows into Asia. And Saudi Energy Minister Khalid al-Falih said last week that the world now needed a minimum increase of 1 million bpd to avoid shortages in the second half of 2018.

Overshooting and balance

OPEC-12 compliance with the 2017 cuts reached nearly 150%, overshooting the target because some members such as Venezuela have seen output decline. The OPEC meeting in Vienna also discussed how to implement the latest adjustment and bring compliance to 100%.

Only a handful of OPEC members (Saudi Arabia, Kuwait, United Arab Emirates) and Russia have the capacity to increase production. That has put them at odds with other producers, such as Venezuela and Iran, which have no spare capacity, and so no incentive to raise production and lower prices.

The other domestic dynamic at play is that Saudi Arabia is in a social reform and infrastructure investment process. While higher oil prices increase government revenue, the country is quite comfortable with current levels. Higher oil prices also increase the value of the national petroleum and gas company Saudi Aramco, ahead of its planned initial public offering next year, which is also part of the government’s strategy for diversifying the kingdom’s economy.

In sum, despite the agreement in Vienna, the oil market may be at best balanced this year, and suffer undersupply if demand rises faster than the International Energy Agency’s forecast.

Looking to 2019, we expect to see rather balanced supply-demand, assuming there are no disruptions. Inventories, in absolute terms, may rise modestly while remaining lower than the five-year average. In a context of more limited spare capacity and the lack of investment seen in the sector in the recent years, oil may become more sensitive to disruption and geopolitics.

The investment case

What does this mean for our investment case? We continue to like commodities as an asset class which can offer investors a hedge against geopolitical and inflation risks in a multi-asset portfolio. Our view on oil remains neutral, with a target price at USD 70. OPEC remains clearly committed to defending this price level, which makes both producers and consumers comfortable.

We also believe that the strong backwardation of the futures curve (where futures prices are lower than expected spot prices) offers an interesting carry opportunity for investors in the oil market.

Last week’s production pledge answers oil consumers’ requests, and as long as supply rises and prices are at least stable, the outcome will be positive for emerging market producers as well as equities.