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Oil prices took a hit in mid-March this year, given concerns over the health of the overall economy after the collapse of several banks (Silicon Valley Bank, Signature Bank, and Credit Suisse).
However, oil prices later spiked after OPEC+ made a surprise cut to output targets. Nine members of the OPEC+ group announced further voluntary cuts, amounting to around 1.66m barrels a day.
While a global economic slowdown was cited as the reason behind the production cut, there is more behind it. OPEC+ is pushing for higher oil prices with little fear of losing market share, and the recent geopolitical tensions could imply production cuts are a retaliation towards the West.
With low inventory levels and little supply response in sight, there are little to no buffers against high oil prices. Oil fundamentals are expected to tighten as we move through the year even if we enter into a recession.
Investors may wish to consider the Blackrock World Energy Fund, if they are seeking a dedicated energy fund. Alternatively, investors can also consider the Blackrock Natural Resources Growth & Income Fund to get a diversified exposure to the commodities sector comprising of energy, mining, and agriculture.
What is happening to oil prices?
Figure 1: Crude oil price year-to-date
Nine members of the OPEC+ announced further voluntary cuts, amounting to 1.66 million barrels a day (bpd), abandoning previous assurances that it would hold supply steady. This also comes on top of the 2 million bpd cuts announced last October. The new cuts will start in May and run through until the end of 2023, with the bulk of the cuts coming from Saudi Arabia, which will reduce supply by 500,000 bpd.
Table 1: Voluntary supply cuts announced by OPEC+ members
|
In ‘000 barrels per day |
Current target production levels |
Voluntary supply cuts |
Voluntary production (May – Dec 2023) |
|
Algeria |
1,007 |
-48 |
959 |
|
Gabon |
177 |
-8 |
169 |
|
Iraq |
4,431 |
-211 |
4,220 |
|
Kuwait |
2,676 |
-128 |
2,548 |
|
Saudi |
10,478 |
-500 |
9,978 |
|
UAE |
3,019 |
-144 |
2,875 |
|
Oman |
841 |
-40 |
801 |
|
Kazakhstan |
1,628 |
-78 |
1,550 |
|
Russia* |
10,478 |
-500 |
9,978 |
|
Total (excluding Russia) |
-1,157 |
||
|
Total |
-1,657 |
||
|
Source: OPEC, reports, ING Research *Russian supply cuts are an extension of recently announced cuts |
|||
Key reasons behind OPEC+ production cut
Concerns over weak demand
OPEC+ production cuts have naturally raised some concerns over the demand outlook. This decision was being described by the Saudi oil ministry as "a precautionary measure aimed at supporting the stability of the oil market”. It was designed to provide price support following pressure from weak macroeconomic sentiment amidst the banking turmoil and recessionary concerns.
Where it stands, the continuing tightness in the labour market and sticky inflation will make it a daunting task for the Fed to cut rates this year, which means the economic damage from higher-for-longer rates will likely snowball. This also comes about as leading economic indicators have been on a downtrend, suggesting that the US economy is likely to slow even further in the months ahead (Figure 2).
Figure 2: Leading indicators are already pointing towards a slowdown in the economy
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Pushing for higher oil prices in the absence of other available supplies
However, we think that the fear of an economic slowdown is not the only reason behind the latest production cuts. OPEC+ benefits from squeezing oil markets to prevent oil prices from dropping too far. The latest cut suggests OPEC+ was not content with Brent Crude trading in the USD 70-80 per barrel range, signalling that the group is willing to defend a price floor above USD 80 per barrel.
A major reason why OPEC+ members can cut production without the fear of losing market share to non-OPEC members is because it is becoming increasingly clear that the US output growth has been slowing, with US shale not coming to the rescue anytime soon.
The US production growth for instance is less than half of what it was before 2020, with overall output yet to return to pre-pandemic levels. Oil production in the US grew from 0.6 million barrels per day in 2021 and 2022, compared to 1.3 million barrels per day per year over 2017-2020.
In fact, looking at US domestic oil producers, the US oil rig count tracked by Baker Hughes has failed to rise in line with prices (Figure 3) and structurally, the oil and gas sector is a market that is defined by underinvestment. This is a persistent problem that is difficult to change, with investment being on a downward trend since 2014.
Figure 3: US domestic oil production are less responsive to prices than in the past
There has been a change in mentality from producers from the days of pumping as much as possible, as energy companies are reluctant to invest as much as they once did in fossil fuels due to investor pressure to maintain capital discipline (Figure 4). Moreover, adding to this lack of desire for investment is the on-going transition in energy markets to lower-carbon fuels. With the green transition underway, we are unlikely to see as much exploration and development of new fossil fuel sources of energy.
Figure 4: Federal Reserve Bank of Dallas Energy Survey reveals the primary reason for underinvestment
Growing tensions with the West
In recent times, OPEC+ has also largely ignored calls from the US and other key consumers to increase oil supply, causing the West to repeatedly criticise OPEC for manipulating prices and siding with Russia despite the war in Ukraine.
In October 2022, when OPEC+ announced their biggest cutback amounting to 2 million bpd since 2020, US President Joe Biden treated the move as a betrayal by the Saudis, with Biden going as far to say that he would re-evaluate America’s decade long-diplomatic relationship with Saudi Arabia.
Tensions have even escalated to the point where US lawmakers have called for a revival of a bill called the “No Oil Producing and Exporting Cartels Act,” known as NOPEC. This act would empower the US Department of Justice to file an antitrust lawsuit against OPEC+, although it is still currently unclear how a US court could enforce a decision against cartel members. Recent actions by OPEC+ could thus be seen as a retaliation towards the West.
Even with a recession, a tight balance will likely remain leading to higher for longer oil prices
With the march towards a US and global recession looking to pick up pace, the demand for oil is likely to slow. Current projections show that the global oil demand growth in 2023 is expected to decline from 2.5 million bpd to 2.3 million bpd in 2023 (Figure 5).
Related article: Market Outlook: The recession drumbeat grows louder. This is what we like and dislike right now
Figure 5: World oil demand growth for 2023
However, there is one bright spot. China is the one major economy where oil consumption is expected to grow significantly this year, after the country abandoned its demand-sapping zero-Covid policy. With this, the nation’s oil demand would likely continue to rebound throughout the year, being forecasted to be 700,000 bpd higher in 2023 compared with 2022.
There are currently little buffers against high oil prices with US emergency oil reserves at its lowest levels since 1984. The reserve currently contains 372 million barrels—almost half as much as its all-time high of 727 million barrels in 2010.
Figure 6: Oil reserves are at historically low levels
This, coupled with the supply cuts, means that oil fundamentals are expected to tighten as we move through the year. Overall, the global oil market is expected to run short of supply in the second half of the year. The implied deficit in global oil supplies would amount to 1 million barrels per day (Figure 7).
Figure 7: Global oil market has been expected to run short of supply
This just goes to show how unique the current situation is, where entering a potential recession does not automatically mean that oil prices would go down, especially if they are pre-emptively being countered by supply-side cuts and long-term constraints on production. As such, we expect higher for longer oil prices to remain.
With this in mind, investors may wish to consider the Blackrock World Energy Fund A2 USD, if they are seeking a dedicated energy fund. Alternatively, investors can also consider the Blackrock Natural Resources Growth & Income Fund to get a diversified exposure to the commodities sector comprising of energy, mining, and agriculture.
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