In its meeting June 2, OPEC+ agreed to speed up its production hikes, pledging to add 648 thousand barrels a day in July and August, about 200K more than it had signalled previously. This move was mildly positive politically, helping to paper over fraught US-GCC relations, and may be a precondition for a set of bilateral meetings, but the increase is small compared to rising demand. It also puts off the tough decisions about how and whether to reallocate production away from those members which are struggling to meet targets. These trends, plus a focus on reducing the cost to consumers, suggest that prices will continue to trend up. Major critical uncertainties are Russian supplies in the wake of increased sanctions and whether global demand will remain resilient to price hikes (mostly).
Focusing on signs of cohesion, preferring to keep Russia in the fold, OPEC+ put off decisions how it will fill the gaps for countries that are already struggling to meet production targets including grappling with Russian production volatility. As the months go on, not only will it be necessary to signal a reallocation of capacity targets in favor of the few (GCC, Iraq, Algeria) countries that have spare capacity, but attention will shift to how realistic those with the capacity can deploy.
Overall, oil prices for freely traded fuel are likely heading up as more of global oil supply is subject to sanctions, and demand is picking up despite high prices. This assumes that Chinese demand picks up as covid lockdowns moderate, higher domestic demand discounts and tax holidays mitigate demand destruction in other jurisdictions and new supplies are slow to enter the market. Moreover, uncertainty around the implementation of Russian oil restrictions will keep a premium on non-Russian supplies and to the extent that Russia is successful in re-directing oil cargos and setting new global prices, demand destruction may be alleviated. All of this is happening with any pressure release on supplies from other sanctioned countries of Iran and Venezuela. Production in non-OPEC+ countries is trending up, especially from the US and Canada, but production increases are limited by labor other inputs as well as transportation.
Growing Share of Global Production Vulnerable to Sanctions
The biggest uncertainty concerns Russian production and exports. with self-sanctioning under way and likely EU oil import phase out, Russia is likely to struggle to meet its new, larger production targets, though any decline may not be linear. Production fell in April but seems to have recovered slightly in May due in part to domestic economic stabilization (domestic demand) as well as some success in rerouting fuel volumes. The logistics and financial hurdles are likely to increase and even if the EU does not quickly announce its partial oil ban, sanctions-sensitive buyers are likely to continue decreasing its import volumes. There is of course a risk that impending sanctions might prompt some buyers to try to get ahead of planned phase-outs, which could add to the volume volatility. All of this implies that Russian production path is likely to be volatile but trending downward in coming months due to challenges accessing equipment, logistics for exports and payments. Not a great time for Russian energy exports and other macro data to become more opaque.
The EU agreement seems set to phase out seaborne oil but not pipeline supplies, but the planned insurance ban will have at least partial extraterritorial effects, limiting oil exports to countries in Asia and other emerging economies. While some countries including India will engage in more direct payments and self-insurance, the direction of travel of sanctions will increase the costs of these cargos. India has been quickest to snap up discounted oil cargos, in part because it has been shifting away from its previous purchases of Caspian crude oil in the face of conflict, storm and political restrictions on those Russian and Kazakh supplies. The impact of the EU measures will depend a lot on the details of the bans, their timeline of phase in and what set of policies if any, that will be used.
The UK has already signalled that it will join the EU in its insurance ban, limiting coverage for potential exports and forcing countries to self-insure. The US and G7+ allies have important decisions ahead about how much to crowd in emerging economies and what tools to use to do so. This involves key decisions on balancing reducing Russian revenues (and reducing their ability to use them) versus the hit to global consumers and whether some global consumers should get a discount. US policymakers in particular are likely balancing the optics of a price cut to India and China and other EM even if doing so also might limit upside to DM consumers. Several potential supporting tools including price caps or partial escrow accounts are still being considered.
Meanwhile, US negotiations with Iran and Venezuela have yet to bear fruit. Neither would provide a lot of supply in the immediate months, though Iran would likely be able to add 500K or more over several months and would likely be able to ramp up more quickly. Iranian talks are reaching another critical juncture as the political timeline for a deal ahead of the mid-terms is evaporating. Next week’s IAEA meeting with a potential censure could be a trigger for a do-or-die moment for the agreement. Admitting a no deal scenario and associated sanctions enforcement would not help address the energy/broader inflation that is top of mind. More than that it would mean abandoning a major policy initiative aimed at bringing security.
The talks with Venezuela are at an earlier phase, with little clarity about what political concessions or anything other than potential energy exports the country might bring to the table. Getting out of the current limbo could be a good sign, but current phase seems to be talks to have talks. Moreover, any negotiation would quickly likely involve not just sanctioned entities in the government, but bring a long line of creditors seeking payment for arrears. Any potential breakthrough might be only temporary and require significant IOC involvement for a swap. Overall, significant investment would likely be necessary to increase production in Venezuela along with big questions about whether the carbon and financial budget should be spent on its heavy oil.
Meanwhile there are many other production issues in other OPEC and OPEC+ countries. These including continued political violence in Libya, fiscal challenges in Nigeria. Meanwhile Kazakhstan continues to be caught between Russia and its fuel buyers, suffering from self-sanctioning of oil that may include Russian molecules despite exemptions and also from pipeline closures. This continues to limit the OPEC+ members who can boost supplies.
Not much Demand Destruction Yet
Domestic demand in major oil producers including Saudi Arabia and other GCC countries is facing seasonal demand increases (air conditioning season), suggesting that some of the limited increase in supply reflects local/regional demand. Higher domestic demand, helped by higher oil prices is likely to boost consumption particularly in Saudi Arabia, with only some of the increased power demand met by renewable energy projects. Oil producing nations are passing on some of the increased costs to their consumers – notably in the UAE- but other sources of new revenues may dampen demand destruction.
So far only a few countries – notably India- have increased oil imports from Russia, taking advantage of discounts which have limited the increase in oil prices. It remains to be seen if the combination of higher food and fuel prices, weaker currencies and rising financing costs will hit domestic demand sufficiently to stop the drawdowns of fuel supplies. Overall, the small amounts being added suggest that in the short-term market is likely to remain tight, especially if China continues to reopen even at a weaker than pre-pandemic growth rate due to lack of stimulus. Demand destruction will kick in for 2023. The recourse to tax holidays and other efforts to cushion consumers will limit some demand destruction though price increases are high enough to dampen demand. It will help the margins of fuel producers and refiners and not do much to send a price signal.
All of these trends will reinforce divergence across Emerging economies with energy producers and more energy efficient consumers outperforming deficit/large importing peers. Overall, there are few winners given the combo of currency, rate adjustment and other policy settings restraining growth and increasing debt burdens. However, fuel and agricultural producers are in better shape than their peers within and between countries. While I don’t believe that a wave of EM debt defaults of large economies is coming, the number of moderate sized frontier markets in financial distress is growing, and political economy costs of higher food import costs are along with it.
Overall this increase in production, and likely future increases will boost revenues, as both prices and volumes are going up. Capital outflows from GCC funds are likely to increase and may become more targeted to a few key jurisdictions where the combination of economic and political returns is greatest. This includes continued demand in key populous regional players (Turkey and Egypt) where they are already exposed, European member states, where countries like UAE, Saudi Arabia and Qatar are also trying to negotiate longer-term investment and tech transfer considerations, select other emerging economies, while still selectively investing the United States. More of the surpluses as they grow, will be invested at home, in particularly for Saudi Arabia, and most of those invested abroad will continue to go to strategic investments.