Analys
The last hurrah from Vienna
We see a close to 100% probability of an extension of oil production cuts from OPEC at the upcoming OPEC meeting in Vienna on May 25. For H2 2017, we see compliance with proposed cuts as a much more difficult issue than the deal itself. We think there is a 95% probability that Russia will sign on for a new six-month production cut period, but we see only a 30% probability that Russia will keep compliance for that period. Oil cuts during H2 2017 will come at a high cost due to seasonally higher production. We believe the next big price turn will come from non-compliance from Russia in particular but also other OPEC countries, as growing US production shows evidence of the futility of subsidising growth there by keeping production off stream. Saudi Arabia seems assured that production cuts at any price are the right way to go; it seems to us that the longer OPEC tries to keep production down, the more such measures backfire.
Core OPEC members give a good lead
The OPEC and several other key producers including Russia have agreed to cut production by 1.8 million bbl/d for H1 2017 to reduce global glut, formally defined as retreating global stocks to normal levels, i.e. the five-year average. It is increasingly clear that the target will not be reached after the first six months of this year. Saudi Arabian oil minister Al-Falih opened up initially for an extension for H2 2017, and last week for nine months, including Q1 2018. Other core OPEC members have gradually confirmed the extension as well. We assume a Brent crude price of USD 50 fully reflects a six-month extension of OPEC production cuts.
Saudi Arabia supports extension
It has become obvious that Deputy Crown Prince Mohammed bin Salman, who has emerged as Saudi Arabia’s leading economic force, was the architect behind the Saudis’ policy U-turn in Doha, leading up to the cut at the official meeting in Vienna in November 2016. In our view, this was confirmed by the shuffle of the Kingdom’s oil minister, replacing Ali al-Naimi after two decades. If this were a game of chess, we would view this as a rokade.
Prince Mohammed has designated divesting Armaco at the top of his agenda, and that forms the basis of the Saudis’ policy and willingness to cut production in compensation for a short-term higher oil price.
Costly mistake
The savvy players recognise the danger of taking real action in cutting production. History is repeating itself. Higher prices have reversed the US production drop, extending the time it takes for the market to balance, and pushing the volume share away from OPEC and toward two non-cut participants, the US and lately also Libya.
We strongly argue it was too early for OPEC to take action. The rebalancing process had another year, perhaps two, before running its course. If OPEC had waited, a number of bankruptcies in the US energy sector would have played out, and some banks would have lost their faith in energy lending for a long time. Instead, US shale oil is growing at the same rate as it did before the 2014 oil slump and production is now higher than in 2014, which was about the time that OPEC initiated its strategy aimed at knocking off higher costs by flooding the market. Costs are dynamic, however, and the low-price era has pushed breakeven levels lower and provided a solid platform for future growth.
Russia: biggest loser in extension deal
We base our strong opinion of a low 30% chance of an implemented cut during the second half on Russia’s seasonal oil production pattern. Russia has shown its usual low interest in active cuts, and takes its cut from a very high October 2016 production as a reference point for the curbs. Russia has cut about 250,000 bbl/d from its pledge of a 300,000 bbl/d cut, but production is still 1.6% higher than in 2016 and export are 2.14% higher than in March 2016. The first quarter is seasonally weak in Russian crude production, while the second half is stronger, and cuts in the seasonal peak require a strong commitment. We doubt that Russia will turn down additional market share for the sake of Saudi Arabia’s Aramco divestment.
Russia has another reason to be careful in long-term cooperation with the Saudis. Russia has been successful in grabbing market share in China, the only oil consumer growing at any significant pace. This is not the right time to give up footprint anywhere, as competition will increase in all markets ahead.
“Everything is fine”
With little chance of action from Vienna on May 25, we think eroding compliance will set the tone after the May meeting. The oil price will likely hover at around USD 40/bbl when the agreement on production cuts vanishes, and an extension of production cuts will not come into question at the second OPEC meeting this year in November-December.
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Brent crude has fallen USD 3/b since the peak of Iran-Israel concerns last week. Still lots of talk about significant Mid-East risk premium in the current oil price. But OPEC+ is in no way anywhere close to loosing control of the oil market. Thus what will really matter is what OPEC+ decides to do in June with respect to production in Q3-24 and the market knows this very well. Saudi Arabia’s social cost-break-even is estimated at USD 100/b today. Also Saudi Arabia’s purse is hurt by 21% US inflation since Jan 2020. Saudi needs more money to make ends meet. Why shouldn’t they get a higher nominal pay as everyone else. Saudi will ask for it
Brent is down USD 3/b vs. last week as the immediate risk for Iran-Israel has faded. But risk is far from over says experts. The Brent crude oil price has fallen 3% to now USD 87.3/b since it became clear that Israel was willing to restrain itself with only a muted counter attack versus Israel while Iran at the same time totally played down the counterattack by Israel. The hope now is of course that that was the end of it. The real fear has now receded for the scenario where Israeli and Iranian exchanges of rockets and drones would escalate to a point where also the US is dragged into it with Mid East oil supply being hurt in the end. Not everyone are as optimistic. Professor Meir Javedanfar who teaches Iranian-Israeli studies in Israel instead judges that ”this is just the beginning” and that they sooner or later will confront each other again according to NYT. While the the tension between Iran and Israel has faded significantly, the pain and anger spiraling out of destruction of Gaza will however close to guarantee that bombs and military strifes will take place left, right and center in the Middle East going forward.
Also OPEC+ wants to get paid. At the start of 2020 the 20 year inflation adjusted average Brent crude price stood at USD 76.6/b. If we keep the averaging period fixed and move forward till today that inflation adjusted average has risen to USD 92.5/b. So when OPEC looks in its purse and income stream it today needs a 21% higher oil price than in January 2020 in order to make ends meet and OPEC(+) is working hard to get it.
Much talk about Mid-East risk premium of USD 5-10-25/b. But OPEC+ is in control so why does it matter. There is much talk these days that there is a significant risk premium in Brent crude these days and that it could evaporate if the erratic state of the Middle East as well as Ukraine/Russia settles down. With the latest gains in US oil inventories one could maybe argue that there is a USD 5/b risk premium versus total US commercial crude and product inventories in the Brent crude oil price today. But what really matters for the oil price is what OPEC+ decides to do in June with respect to Q3-24 production. We are in no doubt that the group will steer this market to where they want it also in Q3-24. If there is a little bit too much oil in the market versus demand then they will trim supply accordingly.
Also OPEC+ wants to make ends meet. The 20-year real average Brent price from 2000 to 2019 stood at USD 76.6/b in Jan 2020. That same averaging period is today at USD 92.5/b in today’s money value. OPEC+ needs a higher nominal price to make ends meet and they will work hard to get it.
Inflation adjusted Brent crude price versus total US commercial crude and product stocks. A bit above the regression line. Maybe USD 5/b risk premium. But type of inventories matter. Latest big gains were in Propane and Other oils and not so much in crude and products
Total US commercial crude and product stocks usually rise by 4-5 m b per week this time of year. Gains have been very strong lately, but mostly in Propane and Other oils
Last week’s US inventory data. Big rise of 10 m b in commercial inventories. What really stands out is the big gains in Propane and Other oils
Take actual changes minus normal seasonal changes we find that US commercial crude and regular products like diesel, gasoline, jet and bunker oil actually fell 3 m b versus normal change.
Historically positive Nat gas to EUA correlation will likely switch to negative in 2026/27 onward
Historically there has been a strong, positive correlation between EUAs and nat gas prices. That correlation is still fully intact and possibly even stronger than ever as traders increasingly takes this correlation as a given with possible amplification through trading action.
The correlation broke down in 2022 as nat gas prices went ballistic but overall the relationship has been very strong for quite a few years.
The correlation between nat gas and EUAs should be positive as long as there is a dynamical mix of coal and gas in EU power sector and the EUA market is neither too tight nor too weak:
Nat gas price UP => ”you go black” by using more coal => higher emissions => EUA price UP
But in the future we’ll go beyond the dynamically capacity to flex between nat gas and coal. As the EUA price moves yet higher along with a tightening carbon market the dynamical coal to gas flex will max out. The EUA price will then trade significantly above where this flex technically will occur. There will still be quite a few coal fired power plants running since they are needed for grid stability and supply amid constrained local grids.
As it looks now we still have such overall coal to gas flex in 2024 and partially in 2025, but come 2026 it could be all maxed out. At least if we look at implied pricing on the forward curves where the forward EUA price for 2026 and 2027 are trading way above technical coal to gas differentials. The current forward pricing implications matches well with what we theoretically expect to see as the EUA market gets tighter and marginal abatement moves from the power sector to the industrial sector. The EUA price should then trade up and way above the technical coal to gas differentials. That is also what we see in current forward prices for 2026 and 2027.
The correlation between nat gas and EUAs should then (2026/27 onward) switch from positive to negative. What is left of coal in the power mix will then no longer be dynamically involved versus nat gas and EUAs. The overall power price will then be ruled by EUA prices, nat gas prices and renewable penetration. There will be pockets with high cost power in the geographical points where there are no other alternatives than coal.
The EUA price is an added cost of energy as long as we consume fossil energy. Thus both today and in future years we’ll have the following as long as we consume fossil energy:
EUA price UP => Pain for consumers of energy => lower energy consumption, faster implementation of energy efficiency and renewable energy => lower emissions
The whole idea with the EUA price is after all that emissions goes down when the EUA price goes up. Either due to reduced energy consumption directly, accelerated energy efficiency measures or faster switch to renewable energy etc.
Let’s say that the coal to gas flex is maxed out with an EUA price way above the technical coal to gas differentials in 2026/27 and later. If the nat gas price then goes up it will no longer be an option to ”go black” and use more coal as the distance to that is too far away price vise due to a tight carbon market and a high EUA price. We’ll then instead have that:
Nat gas higher => higher energy costs with pain for consumers => weaker nat gas / energy demand & stronger drive for energy efficiency implementation & stronger drive for more non-fossil energy => lower emissions => EUA price lower
And if nat gas prices goes down it will give an incentive to consume more nat gas and thus emit more CO2:
Cheaper nat gas => Cheaper energy costs altogether, higher energy and nat gas consumption, less energy efficiency implementations in the broader economy => emissions either goes up or falls slower than before => EUA price UP
Historical and current positive correlation between nat gas and EUA prices should thus not at all be taken for granted for ever and we do expect this correlation to switch to negative some time in 2026/27.
In the UK there is hardly any coal left at all in the power mix. There is thus no option to ”go black” and burn more coal if the nat gas price goes up. A higher nat gas price will instead inflict pain on consumers of energy and lead to lower energy consumption, lower nat gas consumption and lower emissions on the margin. There is still some positive correlation left between nat gas and UKAs but it is very weak and it could relate to correlations between power prices in the UK and the continent as well as some correlations between UKAs and EUAs.
Correlation of daily changes in front month EUA prices and front-year TTF nat gas prices, 250dma correlation.
EUA price vs front-year TTF nat gas price since March 2023
Front-month EUA price vs regression function of EUA price vs. nat gas derived from data from Apr to Nov last year.
The EUA price vs the UKA price. Correlations previously, but not much any more.
Forward German power prices versus clean cost of coal and clean cost of gas power. Coal is totally priced out vs power and nat gas on a forward 2026/27 basis.
Forward price of EUAs versus technical level where dynamical coal to gas flex typically takes place. EUA price for 2026/27 is at a level where there is no longer any price dynamical interaction or flex between coal and nat gas. The EUA price should/could then start to be negatively correlated to nat gas.
Forward EAU price vs. BNEF base model run (look for new update will come in late April), SEB’s EUA price forecast.
Brent crude spikes to USD 90.75/b before falling back as Iran plays it down. Brent crude fell sharply on Wednesday following fairly bearish US oil inventory data and yesterday it fell all the way to USD 86.09/b before a close of USD 87.11/b. Quite close to where Brent traded before the 1 April attack. This morning Brent spiked back up to USD 90.75/b (+4%) on news of Israeli retaliatory attack on Iran. Since then it has quickly fallen back to USD 88.2/b, up only 1.3% vs. ydy close.
The fear is that we are on an escalating tit-for-tat retaliatory path. Following explosions in Iran this morning the immediate fear was that we now are on a tit-for-tat escalating retaliatory path which in the could end up in an uncontrollable war where the US unwillingly is pulled into an armed conflict with Iran. Iran has however largely diffused this fear as it has played down the whole thing thus signalling that the risk for yet another leg higher in retaliatory strikes from Iran towards Israel appears low.
The hope is that the retaliatory strikes will be fading in magnitude and then fizzle out. What we can hope for is that the current tit-for-tat retaliatory strikes are fading in magnitude rather than rising in magnitude. Yes, Iran may retaliate to what Israel did this morning, but the hope if it does is that it is of fading magnitude rather than escalating magnitude.
Israel is playing with ”US house money”. What is very clear is that neither the US nor Iran want to end up in an armed conflict with each other. The US concern is that it involuntary is dragged backwards into such a conflict if Israel cannot control itself. As one US official put it: ”Israel is playing with (US) house money”. One can only imagine how US diplomatic phone lines currently are running red-hot with frenetic diplomatic efforts to try to defuse the situation.
It will likely go well as neither the US nor Iran wants to end up in a military conflict with each other. The underlying position is that both the US and Iran seems to detest the though of getting involved in a direct military conflict with each other and that the US is doing its utmost to hold back Israel. This is probably going a long way to convince the market that this situation is not going to fully blow up.
The oil market is nonetheless concerned as there is too much oil supply at stake. The oil market is however still naturally concerned and uncomfortable about the whole situation as there is so much oil supply at stake if the situation actually did blow up. Reports of traders buying far out of the money call options is a witness of that.
Also OPEC+ wants to get compensation for inflation
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