Leap of faith Leap of faith http://www.federatedinvestors.com/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\article\hiker-jumping-rocks-small.jpg April 9 2021 April 9 2021

Leap of faith

Will production boosts by OPEC and company pay off?

Published April 9 2021
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In a somewhat surprising development, member nations of the Organization of the Petroleum Exporting Countries (both OPEC and OPEC Plus) met last week and agreed to  boost the group’s production by 2.15 million barrels per day (BDP) by the end of July. The group believes that the global oil market is currently undersupplied by about two million barrels per day, and that as the world economy continues to recover from the pandemic, oil consumption will grow from current levels by 4.7 million BPD by the end of 2021.

Their plan is to increase overall production by 350,000 BPD in each of May and June and by another 450,000 in July. Meanwhile, Saudi Arabia plans to gradually reverse its own voluntary one million BPD production cut (which it implemented last January) by the end of July. 

This compromise between the two leading oil countries lays bare their ideological schism. Saudi Arabia (the largest oil producer in OPEC), which has a break-even cost of $90 per barrel, initially wanted to keep production at current levels, given its uncertainty about the sustainability of the global economic recovery from the ravages of the pandemic. But Russia (the largest producer within OPEC Plus), which has a lower break-even cost of about $50 per barrel, argued that they should take advantage of the rebound in global demand and pricing, producing more oil to generate higher revenues.

Roundtrip In early 2020, crude oil prices (West Texas Intermediate, or WTI) collapsed during the pandemic from $65 per barrel on Jan. 8 to a negative $40 per barrel on April 20. The virtual shutdown of the global economy had gutted demand for crude oil, with much of the world’s population sheltering in place and 90% of global airline capacity offline. Storage capacity for crude disappeared, forcing oil producers to fill tanker ships with oil and send them out to sea with no particular destination. At the trough of this cycle a year ago, oil producers were paying customers $40 per barrel to take the unwanted oil off their hands.

As the global economy began to reopen in the second half of last year, oil rebounded to a positive $40 per barrel over the summer. Sitting at an oversold $34 per barrel in early November, WTI doubled to an overbought $68 last month, as Operation Warp Speed proved to be a success and as vaccine distribution in the U.S. accelerated. But oil has settled back to about $60 in recent weeks. 

Gas prices lag Over this same period, gas prices fell a third, from a national average of $2.60 per gallon in January 2020 to $1.75 last April. But over the past year, gas prices are up more than 60% to an average of nearly $2.90 per gallon last month. The American Automobile Association (AAA) motor club projects that gas could hit $4 a gallon in some states later this year, as drivers hit the road again in earnest.

Texas freeze and Suez Canal These two unexpected events contributed to the recent supply/demand imbalance. Brutal winter weather in Texas in February took an estimated 2.5 million barrels of daily crude oil production off the market for a few weeks, with another one million BPD from other oil-rich states. More recently, a shipping bottleneck in the Suez Canal for a week in late March took an estimated 5-10% of crude oil temporarily off the global market.

Covid-19 update While the U.S. is making solid progress on achieving adult herd immunity by Memorial Day, Europe’s progress has been somewhat halting. There have been blood clot concerns about Astra-Zeneca’s vaccine, coronavirus mutations from the U.K. and South Africa appear to be spreading, and Germany and France (among other countries) have locked down again to help prevent another surge in infections and mortalities after the Easter holiday. As a result, it’s unlikely that Europe will be able to fully benefit from summer tourist traffic, which could dent OPEC’s expected growth in global energy demand.

Biden policies a mixed bag Due to environmental concerns, the Biden Administration has already canceled the XL Pipeline project and has banned fracking on federal lands, which have helped to reduce the supply of oil and boost prices over the past several months. But President Biden’s longer-term shift to Electric Vehicles (EV), which is a decade or more away to reach critical mass, is still raising uncomfortable questions now about whether or not we have already achieved peak oil demand for transportation.

But the Biden Administration’s efforts to re-engage in nuclear disarmament talks with Iran could lift their U.S.-imposed oil production sanctions. Because OPEC’s third-largest producer is not currently subject to any OPEC quotas, Iran potentially could add one million barrels per day or more onto the market over the next year or so, which could eventually pressure prices.

Wait-and-see approach Saudi Arabia, Russia, and the rest of OPEC and OPEC Plus believe that if their planned oil production increases over the next several months are premature and serve to destabilize the current supply/demand balance, then they can simply reimpose the production cuts to boost prices. Easier said than done, of course, because orchestrating a coordinated production schedule within OPEC that actually sticks is like herding cats on a good day. Our best guess is that the combination of stronger global demand and carefully calculated supply increases could allow the oil market to grind up to Saudi Arabia’s internal target of $90 per barrel over the course of the next year.

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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

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