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Volatile market conditions

Saudi Arabia wants Opec to keep cutting, despite the steady tightening of the market. It's a risky strategy

Get ready for the oil-market rollercoaster of 2018. Having paused for breath near $70 a barrel, the oil price now seeks direction—but the arrows point different ways. Eighty-buck Brent now looks distinctly plausible. But so, if less compellingly, does $40. The market is at a crux.

Every bullish cylinder is now firing at once. The global economy is roaring ahead. Oil demand is surging. Geopolitical tensions are building. Crude and products inventories are shrinking. Speculators are hoovering up paper barrels. Opec is jawboning. Even the weather in big consumer countries has been cooler than normal.

Lingering in the background are two potentially bearish forces: a big supply reaction, especially from the US, is one; and the other is patchy data, leaving the old oil-market problem of extrapolating future demand trends from past ones. Production seems certain to surge in 2018, though the range of forecasts is big and, aside from North America, the sources are unclear. Price strength may yet affect demand growth too—but, when this happens, it tends only to be visible in the rear-view mirror.

In the meantime, the economic backdrop is robust. The IMF says the world's economy will expand by 3.9% this year and next, 0.2 percentage points higher than its previous forecast. Economists at investment bank Barclays have raised their forecasts for China, the US and other advanced economies and see global economic expansion of 4.2% in 2018. Far from hurting global growth with his anti-trade rhetoric, Donald Trump has instead pulled off a tax cut in the US that has put burners under the American economy and therefore the world's.

Oil-demand forecasts reflect the broad economic upswing. The International Energy Agency is the least optimistic, but its forecast of a 1.3m-barrel-a-day rise in consumption this year is still above trend. Opec expects 1.53m b/d. Barclays points out that in past periods of "synchronous growth" in the world's economy—when green lights are flashing in all the major economies—oil demand has risen by 2m-2.5m b/d. That would constitute a demand shock.

Staying the course

Opec, which has worked unusually hard to tighten balances in the past 18 months, now risks overcooking the market. Here too the signals are unclear. The group's own assessment says that a large overhang in OECD oil stocks remains to be cleared: the inventory was 2.933bn barrels in November, Opec's most recent market report said, meaning the surplus to the five-year average was still 133m barrels. With that in mind, Saudi energy minister Khalid al-Falih used the meeting of the Opec-non-Opec Joint Ministerial Monitoring Committee (JMMC) in Oman on 21 January to say that the cutters must stay the course. No one at the meeting was talking about ditching the cuts, delegates insisted.

But the IEA thinks the surplus is much smaller, putting the stock overhang now at just 90m barrels after an "exceptionally tight" fourth quarter of 2017. Consultancy FGE reckons this has since dropped to less than 70m barrels, at most. "The significance of this is that Opec and its allies may be heading for a misjudgement," FGE said in a note ahead of the JMMC meeting in Muscat. "If these key producers conclude that the stock surplus remains much bigger than it actually is, then it could support their often-stated view recently that there is no need to adjust the current output cut deal". There's nothing more price-supportive than removing supply from a market craving it.

0.65m b/d—Difference between Opec's and the IEA's forecast for non-Opec output

But Opec would rather keep cutting and risk a higher price than end the cuts and risk a drop. Its job now seems plainly to continue talking up the group's commitment to the deal it agreed last year. It hardly seems an honest broker as it does so. For one thing, Saudi Arabia has the IPO of a 5% stake in Aramco in mind—a motivator for it to sustain a strong market until the flotation. "With the Aramco IPO coming this year, the Saudis are now like an activist investor on oil prices," says Joe McGonigle, senior energy policy analyst at consultancy Hedgeye.

Opec's public message (that the cuts will last through the year) is at odds with the private discussions within the group. Internally, Russia's reluctance to keep cutting is now well known. Gulf sources suggest it still sees the June meeting as an appropriate time to quit. This was one reason why the terms of the cuts rollover in November included, at Russia's insistence, a caveat about reassessing the market in June.

To keep prices strong, the Russian get-out clause can't be central to Opec's message; but to keep Russia on board, the caveat needs to remain. Publicly, Falih remains careful to weave this subtlety into his statements. Thus, in Oman, he told Bloomberg TV: "As we approach the re-balancing by the end of 2018, we need to extend the framework, but not necessarily the production levels."

What Falih and Opec do intend is a broad ongoing supply pact with Russia, even when the cuts have expired. Opec secretary-general Mohammad Barkindo has even talked of institutionalising this relationship. In reality, this is already happening with the JMMC—the regular meeting of Opec's key players; a group that has largely become the cutters' politburo.

For now, though, Russia remains in and so the cuts continue. In aggregate they may even deepen, thanks to Venezuela's collapse. According to its own numbers, its output dropped by 216,000 b/d between November and December, to 1.6m b/d, meaning production was 360,000 b/d beneath its quota. Gloomier forecasts for the coming months are now permeating the market, expecting the number to drop as low as 1.3m b/d by mid-year.

Iran uncertainty

On top of Venezuela's demise is the prospect of lost Iranian oil. Trump has given Europe and the US Congress until May to come up with revisions to the nuclear deal. It's highly unlikely that either will. A full US withdrawal from the agreement wouldn't cut Iranian exports as severely as the last sanctions did (1m b/d); but would still have an impact—perhaps removing as much as 400,000 b/d, according to some analysts. Before Opec meets again in Vienna in June, therefore, the 1.8m b/d of cuts could have morphed into something closer to 2.5m b/d. Imagine the price impact of this dearth of supply in a tight market responding to a surge in global economic growth.

Opec, rarely eager or able to stop a price surge, now has a new problem on its hands. The dangers to the oil market of overheating, during a first half of the year that was expected to be slack, are obvious. First, that surging oil prices begin to trim back some of the demand growth—a reaction that will only be obvious months after it happens. Second, that supply and upstream investment soar, reinflating the stock bubble in the short term and even restoring confidence in big capex projects—like those in the oil sands, where unlike tight oil, the developments won't later be turned off again.

Opec would rather keep cutting and risk a higher price than end the cuts and risk a drop

The third danger is that when the market turns again it will turn hard. Such is the extreme speculative length in both Brent and WTI—hedge funds and other investors have amassed more than 1bn paper barrels since June—that when the position unwinds it could be messy.

Opec seems unconcerned, gambling that even at $70/b oil demand will remain robust and the non-Opec supply response insufficient to match it. It forecasts a rise in production outside the group of 1.15m b/d in 2018, far less than its forecast for demand growth (1.5m). In turn, this means the call on Opec's oil will rise in 2018, too, to 33.1m b/d, or about 0.87m b/d more than the group produced in December. All would be well.

By contrast, the IEA expects non-Opec supply to rise by 1.7m b/d in 2018, compared with demand growth of 1.3m b/d. The call on Opec will be 32.3m b/d, just 70,000 more than it is producing now.

This is a huge discrepancy. Both forecasters can't be right. If the IEA's scenario bears out, oil's rally is now on borrowed time, and the disintegration of the speculative position will be a theme in the market over the coming months. Opec really will need to keep cutting just to keep another collapse at bay.

If Opec's more bullish outlook is correct, Brent at $70/b looks under-priced—especially when you throw in the impending Venezuela and Iran supply risks. The group won't just have cleared the excess, it will have primed the market for a damaging price surge. If it believes its own numbers, Opec should be trying to cap the rally, not pump it up. Nothing the group is saying suggests it is aware of the risk.

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