Re: Oil-Update on OPEC+ Agreement/Delta Worries.

Had a nice chat today with @jackfarley96 of @realvision and @warrenpies (airing next week), which forced me to collect some thoughts about recent market developments.

To give some context to this update, this was what I presented on @realvision 3 months ago.

https://www.realvision.com/shows/the-expert-view/videos/is-crude-oil-the-best-inflation-hedge-and-other-oil-questions-9vpD?utm_source=twitter&utm_medium=social&utm_campaign=2021422_EXPVIEW_MR_TW_W1_LINK&tab=details

Since that interview, there have been many developments, and oil has been on an uptrend – albeit a volatile one, going from $61 to $77 to $66 and now back to $72. The backwardation has also steepened:

Warren and I both agree that while “current forward prices are terrible predictors of future spot prices,” inflections from contango to backwardation have predictive power.

I liked Warren’s characterization of the forward curve as a “market management tool” by OPEC+. I agree 100% here. OPEC+ has engineered a perfect dynamic for itself: create supply inelasticity in the short-term while creating supply overhang insecurity over the longer-term.

History has shown that when OECD inventories dip below the “safety stock” level of 2.75B barrels, oil prices are likelier to experience “supply shock” rips. The goal of draining excess inventories down to this level appears to be the key motivation behind OPEC+ policy.

My smart Permian Basin CEO pal thinks the OPEC+ “dream curve” is $85/$65, meaning $85 spot Brent, trailing down to $65 2-4 years out. I too believe that OPEC+ policy going forward will be designed to target this outcome.

Reasons? 1) $85 Brent comes close to balancing KSA’s budget deficit, 2) $65 forward prices are right at the precipice of US shale breakevens, which have increased from $59 to $66 per Capital One.

The recent tiff between KSA and UAE potentially leading to a bigger rift never bothered me: 1) UAE is a bit player within OPEC+, 2) and the 2 main players that matter are KSA and Russia.

The recent OPEC+ agreement 1) extended the last agreement to Dec 2022, 2) increased baselines for 5 countries and results in up to ~2 mmbpd of additional TARGET supply by Sep 2022, which could reverse all the post-COVID withheld supply.

Between these headlines and fears over the Delta variant leading to lockdowns, crude sold off sharply last week. So why has oil rebounded since?

2 reasons: 1) the OPEC+ agreement just creates “supply overhang insecurity” not “supply overhang CERTAINTY” – remember the overarching goal of getting OECD inventories close to 2.75B barrels.

2) Although Delta remains a wildcard given recent alarming spikes in infection rates, the fact remains that hospitalizations are almost all from unvaccinated people, and given that, it is less likely there would be draconian lockdown measures implemented like we saw last year.

GS recently put out this chart that showed that despite the recent outbreaks in Israel and the UK, mobility trends had not really been impacted.

The one area that Delta is most likely to impact is jet fuel – the only distillate whose demand is still materially below pre-COVID levels.

Capital One estimates Delta impact on jet fuel to be no more than 800kbpd but that half of this loss would be made up by increased gasoline/diesel demand as folks opt more for private car travel.

The issue of whether we’re in a “super-cycle” came up again. I previously gave a scenario of how long-cycle capital starvation could lead to very tight/non-existent levels of spare capacity by 2024.

I’ve since seen some research on GCC investments in spare capacity that lead me to think there could be more potential cushion than previously thought, although capacity could still get tight.

The GCC countries are KSA, UAE, Kuwait, Bahrain, Oman and Qatar – the “Haves” within OPEC+ while there are many “Have-nots” like Iran, Iraq, Venezuela to name a few. The rumor is that the GCC “Haves” are aggressively investing to increase their spare capacity – especially KSA.

While overall Middle-East rig counts are still 35% below the pre-COVID baseline, this distinction between “Haves” and “Have-nots” could spell a scenario where GCC countries disproportionately increase spare capacity even while it appears overall rig counts remain muted.

Furthermore, despite the anecdotes of “aging fields,” the fact remains that GCC decline rates have remained very low (like 2%/yr) relative to non-OPEC sources, so “a little goes a long way” in terms of spare capacity capex.

At any rate, this is all speculative, and I assign it into the “too hard” pile. As I tweeted earlier today, “I’d much rather be generally right than precisely wrong.”

What I hope to be “generally right” about is that the post-COVID alliance between KSA and Russia will govern forward OPEC+ policy to guide the forward curve to that $85/$65 nirvana curve– regardless of what happens with the Delta variant.

Whether or not we’re in a “super-cycle” or not (which I define to be a scenario in which demand exceeds all global spare capacity and OPEC+ essentially loses control of the forward curve) remains to be seen.

Because COVID essentially wiped out 3 years of demand growth and we are still climbing out of this deficit, the engineered supply inelasticity is creating a forward curve that is providing OPEC+ both TIME and CAPITAL to expand spare capacity.

But with shale’s muted response thus far (due to capital discipline, ESG shackles, end of high-grading, etc.), it looks like OPEC+ is likely to regain the mantle of “swing producer” once again.