Oil prices anticipate increase in production

Oil prices are sending mixed signals about the production-consumption balance in the second half of 2021 and early 2022, implying the market is currently tight but likely to see significantly more output in the near future.

In the physical market, Brent’s five-week calendar spread is trading around $1.50 per barrel, which puts it in the 93rd percentile for all trading days since 2010, confirming the market is currently short of crude.

In futures, Brent’s six-month spread is around $3.70 per barrel, also in the 93rd percentile for all trading days since 1990, signalling traders expect inventories to remain below average.

But front-month futures prices have risen less than 10% over the last two months, implying traders anticipate substantially more crude could be made available to the market without much further increase.

The current mix of flat prices and spreads is consistent with the view OPEC+ will increase production significantly in the remainder of 2021 and early 2022 to satisfy increasing demand while keeping stocks relatively low.

Earlier this month, OPEC+ members agreed in principle to raise output by 2 million barrels per day between August and December, though a final decision was blocked by disputes over production levels after April 2022.

The current constellation of prices and spreads implies most traders think agreement along these lines will be reached soon to ensure the shortage of petroleum does not worsen further (https://tmsnrt.rs/2UgQWwV).

SENSITIVE THRESHOLD

After adjusting for inflation, Brent prices are already above their long-run average, and cash flows are high enough to cover both investment in production and adequate returns to shareholders and governments.

While most producers in OPEC+ and elsewhere would like prices to be even higher as they recover from the trauma of last year’s price slump, consumer and political scrutiny will intensify if prices climb above $80.

If producers are withholding significant volumes of output while prices move above $80, consumers and consuming-country governments are unlikely to be sympathetic and understanding.

Political sensitivity about rising oil prices is already evident in U.S. government pressure on Saudi Arabia and the United Arab Emirates to settle their dispute over production baselines.

In theory, the U.S. and European governments should welcome higher prices, since they sharpen the incentive to reduce consumption and accelerate the transition to alternative forms of energy.

Higher prices would be the fastest way to encourage widespread adoption of electric vehicles, but most consumer-country governments remain anxious about the impact on headline inflation and the short-term political costs.

Prices rising above $80 would be progressively unstable as producers boost output, while consumers switch to alternatives, and consumer-country governments ramp up antitrust enforcement and energy transition planning.

In the short term, a range of $70 +/- $5 is the one likely to minimise friction between producers and consumers, keeping petroleum competitive as a source of energy while ensuring sufficient revenues for investment.

This is slightly higher than the $65 +/- $5 that seemed likely in the first quarter because of the earlier and stronger recovery in petroleum consumption as a result of a rapid global economic expansion.

But the basic outlook is unchanged: moderate prices minimise friction between producers and consumers, while a further surge in prices will increase pressure for a faster energy transition.

(John Kemp is a Reuters market analyst. The views expressed are his own)

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