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Edward Bell - Senior Director, Market Economics
Published Date: 07 July 2019
If OPEC+ needed any confirmation from markets that production cuts were losing their significance in the short-term, last week’s price action should be examined in detail. OPEC+ agreed to extend their production cut deal until Q1 2020 yet both WTI and Brent closed lower on the week. WTI gave up 1.6% to close at USD 57.51/b while Brent futures fell 3.5% to end the week at USD 64.23/b. Soft manufacturing data out of the US and Germany along with persistent expectation that the Federal Reserve will need to cut rates this month kept demand considerations front of mind and more influential than supply restraint. Central banks globally are positioning themselves in a more dovish stance to try and support growth in the tail-end of the business cycle. While a softer dollar from an imminent Fed cut—not our core view—should notionally be supportive for commodities, the context of slowing global growth will outweigh any benefit.
OPEC produced another month in June of strong over-compliance with its share of production cuts. Aggregate compliance was 155%, according to Reuters data, with Saudi Arabia achieving 259% of its target while the UAE hit more than 120%. Iraq came closer to hitting its target last month at 73% compliant. As we outlined in our response to the extension of the OPEC+ deal, cutting production is a heavy-handed tool and will have more of an impact on economic performance in OPEC+ countries than it will on global oil balances (see “OPEC+ extends cuts for limited gain”, published July 3 2019).
Short-term time spreads weakened in Brent and WTI last week. In Brent the 1-2 month spread closed the week at USD 0.39/b in backwardation compared with more than USD 0.8/b a week earlier while in WTI the narrow contango widened. Longer-dated spreads deteriorated as well with Dec spreads for 19/20 recording smaller backwardations in both benchmarks. Dubai spreads managed a small pick-up at the end of the week but on average over five days were weaker. Saudi Arabia and Kuwait have reportedly come to an agreement to allow production from the Neutral Zone to resume after years of no output. The capacity of the Neutral Zone is around 500k b/d shared between two fields. An increase in output would help to offset some of the current shortfall in heavy, sour barrels thanks to disrupted supplies from Venezuela and Iran but increasing output now would seemingly be at odds with the OPEC+ decision to restrict output.
Investors continued to pull long positions out of Brent last week while adding to their shorts. Net length in Brent futures and options has declined for eight weeks in a row and as a share of open interest fell to just 8.2%, its lowest level since February. The narrowing backwardation in Brent spreads will help accelerate the decline in net length as roll yield strategies become uneconomic. If the front end of the curve threatens a move into contango Brent could be subjected to significant downside volatility as net length, while declining, is still relatively large on a contract basis. However, options pricing are not reflecting a significant downside yet as 25D risk reversals closed the week with a smaller put premium.
Source: EIKON, Emirates NBD Research.
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