John Kemp, Reuters
OPEC and oil traders are now in fundamental disagreement about the market outlook, and the standoff is fueling a sharp rise in prices that could spell trouble for the global economy over the next 18 months.
The overall balance between supply and demand is “healthy,” according to a September statement from the Joint Ministerial Monitoring Committee of OPEC and non-OPEC producers.
The committee expressed its satisfaction regarding the current oil market outlook, according to a press statement released afterwards.
But where the committee sees a balanced market and warned about downside risks to demand in 2019, traders see a market that is increasingly tight and are worried about the adequacy of future supply.
Front-month Brent crude futures have jumped by almost $14 per barrel (20%) since the middle of August, including an increase of nearly $6 (7%) since the JMMC meeting, to their highest in almost four years.
Brent’s six-month calendar spread, which has been a good proxy for the global supply-demand balance in the last 25 years, has risen by $2.50 per barrel and swung from a small contango into a pronounced backwardation.
The recent intense backwardation in Brent futures close to delivery and the surge in Oman crude prices to a rare premium over Brent are all consistent with a market that fears physical shortages in the next few months.
Hedge funds and other money managers have boosted their bullish position in Brent by 172 million barrels (MMbbl) since late August, an increase of more than 50%, including 50 MMbbl in the aftermath of the JMMC.
Nearly all hedge fund managers expect oil prices to rise rather than fall in the short to medium term, according to exchange data. Fund managers hold bearish short positions in Brent amounting to just 27 MMbbl, the second-lowest level in the last five years.
Across the entire petroleum complex, including crude and refined fuels, hedge fund short positions have fallen to the lowest level since at least 2013.
Where OPEC is worried about the potential for a slowdown in oil consumption growth as a result of rising prices and a possible downturn in the global economy, traders are more worried about the impact of sanctions on Iran.
The standoff between the JMMC, in reality Saudi Arabia, its most powerful member, and oil traders about the state of the oil market is reminiscent of earlier periods of rising prices.
OPEC and traders fundamentally disagreed for almost the entire run up in oil prices in 2007-2008, with OPEC insisting the market was well-supplied while traders continued to bid up prices amid concerns about shortages.
Experience suggests prices will continue rising until: (a) evidence of demand destruction becomes clear, or (b) the increase in prices forces a reaction from OPEC and its allies.
OPEC tends to react to price changes rather than lead them, which is why its influence over the oil market is usually overstated by many commentators.
In this instance, prices will continue rising until there is clear evidence of a slowdown in oil consumption growth, or an adjustment in production and sanctions policy from Saudi Arabia, Russia or the White House.
Traders are hunting for the price threshold that forces one of those developments. In the meantime, the blame game is heating up, with the White House and OPEC each trying to claim the rise in prices is not their fault.
U.S. President Donald Trump has blamed OPEC for rising prices in a message on Twitter on Sept. 20 and in a high-profile speech to the United Nations on Sept. 25. Trump has also reportedly discussed oil supplies and prices in a phone call with the king of Saudi Arabia on Sept. 29.
Despite close coordination between the United States and Saudi Arabia on the issue of Iran sanctions, neither wants to be blamed for the escalation in fuel costs.
The recent rise in oil prices confirms closely to the traditional boom-bust pattern. Oil prices are not inherently self-stabilizing and display strongly non-linear and cyclical behavior.
The oil market cycles between periods of over- and under-supply. The market is rarely balanced or in equilibrium except by accident and not usually for very long.
Experience strongly suggests oil prices will continue on a rising trajectory until softening consumption growth or an acceleration in production knocks them onto a new course.
Position-building by hedge funds and other traders will accelerate and exaggerate the price movement in the short term but is not the underlying cause of volatility.
If the past is any guide, and it usually is, OPEC and its allies will resist changing production, citing concerns about consumption and the growth in alternative supplies, until the political pressure on them becomes overwhelming.
By that point, prices will already be close to peaking, extra OPEC and non-OPEC supplies will come too late, with consumption already slowing, and add to the subsequent slump.