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Oil markets look past OPEC for now

Edward Bell - Senior Director, Market Economics
Published Date: 03 February 2022


OPEC+ agreed to increase production by 400k b/d in March, in line with our expectations. With OPEC+ returning production at a gradual pace there looks to be no short-term risk to oil prices falling as actually delivering the additional barrels may prove a challenge for the producers’ alliance. OPEC+ itself is projecting a surplus in oil market balances this year, justifying the go-slow approach to returning barrels taken off during the peak of the pandemic in 2020.

Upside risks in force in short term

OPEC+ has struggled to consistently hit its monthly production increases as lagging investment in some smaller producers has eroded the steadily rising output from members like Saudi Arabia, the UAE and Iraq. For the OPEC members of the bloc, they only managed around two-thirds of their allocated increase in January according to market surveys of production. There may be growing diplomatic pressure from economies like the US on their allies within the OPEC+ bloc to increase at a faster pace but as we saw in Q4 2021, there appears to be little urgency on the part of Saudi Arabia or others to increase oil production by a larger degree. A faster pace of supply additions would erode the already narrow buffer of spare capacity within OPEC+, held mainly by a few producers in the Gulf region, but the strain on spare capacity would become more apparent should supply elsewhere be interrupted for a prolonged period.

With the threat of a geopolitical incident in Eastern Europe hanging over markets, the near-term risks for oil prices look skewed to the upside. A conflict involving Russia, one of the world’s largest exporters of energy products, is an enormous binary risk for oil prices and the prospect of US or EU sanctions on Russian oil exports will keep a strong bid under oil for now.

But downside risks are there too

There is a chance that oil markets have priced in a disruption to supply well ahead of it even materializing. Should a diplomatic solution be found to the pending crisis in Eastern Europe then there is scope for a considerable downside adjustment to oil prices, especially in the context of the surpluses expected from OPEC+ itself as well as the IEA. Moreover, producers outside the bloc show no sign of halting upstream additions. Exxon and Chevron have both planned large production increases this year for their assets in the Permian Basin in the US.

Hanging over the market too are non-commodity factors; namely tighter monetary policy from the US and other central banks and the threat of Covid-19 flaring up again, particularly in a critical import market like China. An aggressive hiking cycle from the US Federal Reserve and a stronger dollar will be a headwind to commodities generally this year while China’s zero-Covid policy will be a barrier to stronger oil demand.

Positioning in oil markets is almost entirely one way. Brent options skew show little downside risk protection while activity on call options at USD 100/b or higher for upcoming maturities is growing quickly. Futures markets show net length among speculators has been relatively stable for the last several months.

The geopolitical risks in Eastern Europe and the supply additions from OPEC+ itself and others look to be cancelling each other out for now, leaving oil prices delicately balanced. A resolution of either dynamic—a de-escalation of geopolitical tensions or larger supply increases from Saudi Arabia for instance—could prompt a disorderly unwinding of long positions and see prices correct downward sharply.