Excell with Options: Do OPEC signals mean Oil puts expect to cash in?
Executive summary
It has been quite a while since Excell with Options looked at the oil market, having last discussed it at the end of January. Suffice it to say, a lot has happened since then. At the time, we looked at the various puts and takes, the drivers of potential supply disruptions, and the sources of demand changes. Additionally, we looked at the aggregate supply and demand as measured by the EIA.
Stating “If we put all of this together, we can see that there are potential impacts on both the supply and demand of oil. As with any commodity, the price will be impacted by the supply and demand of the product over every time horizon. Using U.S. Department of Energy data that measures world consumption and world supply, I created a custom index in Bloomberg to measures this supply & demand imbalance in percentage terms. We can see that whenever we get more than 2% out of balance (areas I have circled) there is an impact on price. The 2014-2016 bear market for oil was a period when the supply of oil was outstripping demand. Independent oil producers, using the new fracking technology, oversupplied the product. Fast forward to the end of 2020 and all of 2021. Demand levels have returned to pre-Covid levels, yet supply has not kept pace. Perhaps this is due to disruptions in US pipelines, challenges in Middle East shipping lanes, or unrest in countries like Kazakhstan.”
I have updated the custom index which uses that same data. Figure 1 shows the supply and demand balance, according to EIA data, has come back down to zero over the last six months. There have clearly been other drivers of supply disruptions, but there has also presumably been demand destruction from the persistently higher prices and now the fears of a slowing global economy. Perhaps it is this condition of moving back toward balance in supply and demand which has led to the move off the highs in the generic front month crude.
Figure 1: Oil supply and demand versus generic front month crude
While the world may be in balance, the Administration is not resting. President Biden recently returned from a trip to the Middle East to discuss many issues. One issue that was discussed was Energy Security, particularly in the meeting between the U.S. delegation and that of Saudi Arabia. Per the White House, the steps discussed amounted to increased production that will help stabilize markets, as the press release indicates.
Figure 2: White House press release on U.S./Saudi Arabia meetings in July
The spare capacity of OPEC, or the ability to produce more oil at the margin, has long been a topic of discussion. As with most market drivers, there are bulls and bears. Those that believe there is meaningful flexibility for OPEC to bring capacity online to reduce the volatility in market prices and those market players that are more pessimistic in the actual amount of capacity OPEC, especially Saudi Arabia, can produce. According to Reuters, the amount of spare capacity could drop to less than one million barrels per day by the end of the year. With little wiggle room in capacity, the potential for increased volatility in price remains a risk.
Figure 3: OPEC spare capacity
What will this mean for the market going forward? Where will the extra supply come from in the event a global slowdown does not bring down demand from current level? In a separate Reuters story, we might have some clues as to where the ‘spare capacity’ can come from. Saudi Arabia has more than doubled the amount of oil it imported from Russia for its own domestic power uses. This, in turn, potentially frees up oil for the Kingdom to export to other countries that need it. The new OPEC+ quota includes Russian production, but this has been constrained by sanctions. Is this a path to be able to access more of this production?
Figure 4: Saudi Arabia imports of Russian oil
With the next OPEC meeting on August 3, the spare capacity and therefore the global supply of oil is the major issue on traders’ minds. The IEA looks at the issue from an OPEC+ standpoint and see the UAE and Saudi Arabia as the two potential sources of new supply, assuming that there are no changes to the sanctions on Russia, and assuming Russian oil will not continue to be used as domestic replacement that allows for even more capacity than in the chart below. Suffice to say, there is a good deal of uncertainty as the market heads into the next OPEC meeting.