Oil risks overheating after Opec+ leaves output unchanged

An employee shows a sample of crude oil in the Yarakta oilfield, owned by Irkutsk Oil Company (INK), in Irkutsk Region, Russia, in this picture illustration taken March 11, 2019. [Reuters]

By deciding to leave production unchanged for another month at its meeting on Thursday, Opec+ risks causing the oil market to overheat and creating conditions for more instability in the future.

The expanded group of oil exporters defied the expectations of a majority of analysts and traders that it would respond to escalating prices and an intensifying backwardation in the futures market by raising output.

But the decision should not have come as a complete surprise. It is consistent with the group’s behaviour over the last decade, and with Opec-only behaviour for the decade before.

The group’s decision-making has usually lagged market conditions when prices are falling – but especially when they are rising. For all the group’s rhetorical commitment to market stability, past production decisions reveal its goal is to obtain the highest possible price in the short term.

In an environment of rising prices, the group has continued restricting output below its potential level to enjoy a temporary windfall in terms of higher prices.

Opec+ does not have a track record of responding proactively to add extra barrels to the market to cool a rapid rise in prices and intensifying backwardation.

Extra barrels have mostly come from declining compliance among individual Opec+ members with an existing output agreement and a rapid expansion in US shale production.

As a group, Opec+ has usually allowed the market to overheat, until accelerating US shale production, decelerating consumption, or both, threaten to push the production-consumption balance into surplus.

Before the decision, front-month futures prices had returned to levels before the onset of the first wave of the coronavirus and were in a range that has caused US shale production to increase over the last decade. Most of the extra stocks that accumulated in the second quarter of 2020 as a result of the epidemic and volume war between Saudi Arabia and Russia have been digested by the market.

OECD commercial petroleum inventories are back in line with the pre-pandemic five-year average for 2015-2019, according to estimates prepared in February by the US Energy Information Administration.

As a result, Brent futures for the first six listed contracts have moved into a backwardation of $4 per barrel, consistent with an under-supplied market in which stocks are at or below the level desired by traders and refiners.

Brent’s six-month calendar spread has risen to the 95th percentile for all trading days over the last three decades, signalling production is running well below consumption and inventories are expected to become very low.

In the physical market, dated Brent’s calendar spread for the first five weeks is in a backwardation of 32 cents per barrel, the 65th percentile for all trading days since 2010, confirming the market is moderately tight already. Opec+ chose to ignore these indicators of a rapidly tightening market and focus instead on the “uncertain market conditions” and the need to “remain vigilant and flexible”.

“The meeting recognised the recent improvement in the market sentiment by the acceptance and the rollout of vaccine programmes and additional stimulus packages in key economies,” the group said in a statement.

It urged all members “to remain on the course which had been voluntarily decided and which had hitherto reaped rewards”, an implicit reference to higher prices and revenues.

The petroleum price cycle appears to be repeating itself, with Opec+ opting to continue restricting output rather than respond to falling inventories, rising prices and increasing backwardation.