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OPEC+ failure raises oil market uncertainty

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OPEC+ failure raises oil market uncertainty

Uncertainty in the oil market has increased after this month’s OPEC+ meeting failed to reach agreement on future oil supply. In this Macro Flash Note, GianLuigi Mandruzzato looks at the reasons for the disagreement and possible future developments. Although no scenario can be ruled out, it is reasonable to assume that the agreement is only postponed and that OPEC+ will do everything in its power to contain oil price volatility.

The OPEC+ meeting in early July had a surprising outcome1. The meeting, scheduled for 01 July, was expected to lead to increased production to meet the forecast summer demand recovery. The main uncertainty was the size of the supply increase that would be approved. Instead, the meeting was first extended to 02 July, then adjourned to 05 July and finally concluded without any agreement being reached.

The reason is that the United Arab Emirates (UAE) opposed extending the production limits agreement beyond the current deadline of end-April 2022. Indeed, the UAE is requesting that for the period from end April 2022 to the end of next year, the reference production level for defining its quota be raised to take into account increased production capacity following recent investments2.

At the same time, according to press reports, the UAE agreed to increase supply in the period August-December 2021 by a total of 2 million barrel per day (mbd) as proposed by Saudi Arabia and Russia. This would have been in addition to the 0.44 mbd increase already agreed for July, increasing overall OPEC+ supply by around 2.45mbd in the second half of the year.

Chart 1. Global oil market balance (mbd)

Source: International Energy Agency and EFGAM calculations.

Many observers fear that due to the failure to reach an agreement, oil supply will be insufficient to meet rising demand and that prices could surge. According to International Energy Agency (IEA) projections published in mid-June, global oil demand will rise by 4.4 mbd between the second and fourth quarters of 2021. The IEA also estimates that oil supply from non-OPEC+ countries, of which the largest producer is the US, is expected to increase by about 1.3 mbd. The amount of OPEC+ supply needed to balance the oil market would still be about 0.65 mbd higher than what OPEC+ countries would have produced based on the agreement proposed at the July meeting last meeting. The "planned" supply deficit by OPEC+ would have sparked a further moderate decline in petroleum products stocks from levels that remain high, especially when measured in terms of days of oil consumption, and consolidated prices around current levels. The risk is that the supply deficit is now much larger, and that upward pressure on prices increases.

This is a problem for OPEC+ for several reasons. First, high oil prices in a situation of rising demand will encourage US shale oil producers to increase production and gain market share. US oil production is about 2 mbd below pre-Covid levels and could be significantly increased in a short period of time.

Secondly, if oil prices rise much further, they will eventually reduce demand for oil products. Not only will consumers look to save on their energy bills, but global growth will slow down, reducing oil demand from the producing sectors as well. The pressure on oil prices could then turn downwards again.

Finally, high oil prices will accelerate the energy transition to renewable sources. The transition is needed to achieve UN targets for limiting greenhouse gas emissions and global warming. If prices for renewable energy become even cheaper than for fossil fuels, this will provide further impetus to green investments, accelerating the structural reduction in oil demand expected in the coming decades.

Therefore, it would be unsurprising if the rift within OPEC+ is repaired in the coming weeks with a fudge on 2022 production targets possibly presented as a diplomatic victory for all parties. It seems reasonable to expect that the production increase discussed by OPEC+ will be broadly implemented and that the UAE will be granted a partial increase in production quotas from May 2022 in exchange for extending the agreement on production limits until at least the end of next year.

In this scenario, a drop in oil prices in the coming months would be expected. This would also reflect the overvaluation of current prices relative to fundamentals that the econometric analysis shows. Starting from an overvaluation situation, our model predicts that the WTI oil price should fall in the coming quarters towards USD60pb, a similar pattern as incorporated in futures contracts.

Chart 2. WTI price and model forecast (USD/b)

Source: Refinitiv and EFGAM calculations.

If this proves a good guide to future developments, the inflation rate will soon peak. Over the coming quarters, moderating crude oil prices would help inflation to return to levels closer to central bank targets, supporting the expectation that monetary policy will remain accommodative for an extended time.

Chart 3. WTI oil and G7 inflation (yoy)

Source: OECD, Refinitiv and EFGAM calculations.

1 OPEC+, formed in December 2016, counts 23 members, including all OPEC countries, Russia, Mexico and some other oil-producing countries, but not the US. OPEC members Iran, Iraq, and Libya are currently exempted from production limits.

2 The distribution of oil production cuts is established by taking as a reference level the production of each country as of October 2018, except for Saudi Arabia and Russia for which the reference production is 11mbd.