Oil and Copper - Separate Ways Part 1

Why oil supply could continue to outstrip demand, despite an improving global macro environment

While the band Journey originally formed in the early 1970s, it wasn’t until later in the decade and early 1980s that they truly became a household name, and today they are arguably one of the most sampled artists with their songs appearing in numerous television shows, movies, and Broadway theater. In fact, the song “Anyway You Want It” made an appearance in Caddyshack with Rodney Dangerfield, then again twenty-five years later in The Simpsons episode where Rodney Dangerfield has a cameo as Homer’s new friend.

Technically, Journey is still together making new music, but unfortunately without Steve Perry, who was the original singer. With so many great songs in their portfolio, I was thinking about their other, slightly less famous song, “Separate Ways” with regards to our team’s outlook for oil and copper prices. Not because the video for “Separate Ways” is ridiculous and embodies the 1980s perfectly, but rather the title personifies the potential medium to long-term interaction between these two commodities.

As you’ll see shortly, we believe that long-term trends could result in oil and copper moving in opposite directions. Although the two, like most commodities, have historically been positively correlated that relationship may be breaking down due to structural changes in the global economy. But why are we even talking about oil and copper to begin with?

Oil is an obvious one given its economic importance to the global economy and implications for many nations that are dependent on the product either as exporters or importers. Fluctuations in the price of oil can dramatically affect each nation’s respective current account and fiscal health. In addition, oil can be a significant contributor to inflation and inflation expectations.

Copper may be less obvious as to why we chose it, and again we’ll get into the finer points in a follow up newsletter. But at a high level, we’ve found that like oil, some emerging markets are wholly dependent on it, which also means that like oil it can at times get caught up in geopolitical ambitions.

We’ll break down our analysis into a series of mini newsletters analyzing the various factors driving their prices. For this publication, let’s look at the various factors affecting the supply-demand dynamics including recent decisions by OPEC, the rise in US demand, and the pending US-Iran nuclear deal. In a follow up piece, we’ll go deeper on geopolitical tensions between UAE and Saudi Arabia affecting our view on oil, followed by additional pieces on copper. So here we go…

Oil price volatility largely due to supply-side effects

Oil price collapsed in the summer of 2020 reaching a multi-year low of USD 32/bbl due to COVID-19 as no one was driving or flying (technically, futures prices went negative monetarily). However, even before economies began to heal, prices started to turn around, especially towards the end of 2020 and early 2021 due to the prospects of potential economic expansion and a post COVID-19 global rebound. And despite a brief respite in prices in early March, prices continued to rise throughout the spring of 2021, reaching a multi-year high of USD 75/bbl in July. The rise in prices was mostly supply-led given that OPEC+ cut production during COVID-19 on the back of dwindling oil demand.?Specifically, OPEC+ wanted to cut cumulative production by 10 million bbl/day, which was eventually curtailed to around 5.8 million bbl/day. The cuts held for most of 2021, and even though actual demand may not have risen, the prospects of rising demand as economies opened, juxtaposed against the lower base of production by OPEC+, led to the sharp rise in prices in the first half of 2021.

Crude Oil Prices over the past 5 years

(Source: Bloomberg)

Consequently, large oil importing nations began to voice their concerns to OPEC+ members about the sudden rise in prices. As noted, economic growth had not firmly taken hold with many countries still vulnerable to economic shocks, particularly emerging and frontier markets, many of which lack(ed) the dollar reserves to support higher import expenses, while also not having ample fiscal space to blunt the internal effects of higher energy costs. Meanwhile, inflation fears started to gain momentum. Accordingly, rising import prices was the last thing they needed with fears that a 1970s style stagflation could take hold. Granted oil alone would not be the only potential culprit if inflation took off, but it could be a key ingredient. The behind-the-scenes lobbying appeared to pay off as OPEC+ went into their early July meeting where production increases were on the table.

However, the July meeting ended in a stalemate due to opposition from the UAE. OPEC+ members were poised to approve increasing production by 400,000 bbl/day each month starting August and running through 2022. The goal was to bring production back to pre-pandemic levels by the end of 2022. While the UAE supported increases for 2021, it balked at the 2022 increases arguing that baselines (country-level production quotas) should be discussed and revisited. This stemmed from UAE’s ongoing concerns that Saudi Arabia continues to be the main beneficiary of OPEC+, and even when the COVID-19 production restrictions went into place, Saudi Arabia was not affected much because in percentage terms its production, and thus dollar inflows, remained relatively high compared to smaller countries. But we’ll get into a more comprehensive explanation of the geopolitical drivers between the UAE-Saudi Arabia disagreement shortly, and towards the end of the oil section of this piece.

Baselines changed with production set to increase

This then brings us to the July 18th meeting. In the run up to this gathering, baselines were discussed, and amendments agreed to. OPEC+ announced that UAE’s quota would increase from 3.16 million bbl/day to 3.5 million, which is still below its desired 3.8 million, while Saudi Arabia’s will increase from 11 million to 11.5 million, alongside Russia, which will receive a similar allowance.

Granted, in nominal terms Saudi Arabia and Russia receive a bigger increase than UAE, but in percentage terms their quota growth pales in comparison to UAE’s gains. Thus, UAE will stand to see more benefits from a baseline standpoint.

Meanwhile, Kuwait and Iraq will see their baseline increase by 150k bbl/day to 2.959 million bbl/day, and 4.803 million bbl/day, respectively. Algeria and Nigeria will not see any baseline increases.

It’s not clear how these decisions were agreed upon, particularly in such a short period of time and given the growing animosity between UAE and Saudi Arabia. Furthermore, the increases seem somewhat arbitrary as Russia’s total potential capacity isn’t even close to 11.5 million bbl/day. ?With a maximum current capacity of around 10.5 million bbl/day, the new figures are hardly relevant caps for Russia thereby giving Russia nearly unfettered production.

The point though is that at the July 18th meeting OPEC+ essentially signaled that production will ramp up, and quite aggressively at that. And the Russia case shows that the decision making is more political than practical, which then raises the risk that OPEC+ may overshoot actual demand. But that aside, the 400,000 million bbl/day increase suggests that over the 16-month window, total OPEC+ production is poised to increase by 6.4 million bbl/day, thus exceeding the COVID-19 cut, which was 5.8 million bbl/day.

Iran and US can add even more supply onto markets

Now that’s just OPEC+. Let’s then layer on the fact that if the US and Iran work out a new nuclear deal, then that’s another 2-3 million bbl/day that could hit the markets. Thus by 2022, or 2023, it’s quite possible that global crude supply is much higher than in 2019.

Also, we shouldn’t forget about US capacity. The latest EIA data shows us that domestic US production hit 11.4 million bbl/day, which is somewhat back up to pre-pandemic levels. Thus, in contrast to OPEC+, US capacity has already scaled back up, and we haven’t even finished out 2021 yet. It’s possible that production ramps up even further back up to the early 2020 peak of 13.0 million bbl/day.

In aggregate, what does this mean? Well prior to the OPEC+ announcement, global production was forecasted to hit 97 million bbl/day in 2021, and 102 million bbl/day in 2022. But post OPEC+ announcement, and with the potential Iran deal, we could see this number increase to around 100 million bbl/day in 2021, and maybe approach 110 million bb/day in 2022.

So clearly supply has rebounded in some markets, like the US, and is set to rise in others, like the UAE and Saudi Arabia.

While US demand has likely rebounded quickly too, globally it’s a different story

But how about demand? Well, in the case of the US, it does seem that demand is rising. EIA data reveals that US oil imports are around 6.2 million bbl/day, largely where the number was a year ago during COVID-19. But this alone does not imply that US demand is weak because we know that US production has grown, thus negating the need for more imports just yet. A key data point to consider is that crude oil supplied to refineries rose to 16.1 million bbl/day in July, which is 2 million bbl/day more than this time last year. Thus, demand for refined goods has grown tremendously.

Meanwhile, crude oil stockpiles have fallen to 437 million barrels, from 531 million last year, so clearly there’s also a drawdown in inventories taking place. Thus, not only is the US ramping up production, the domestic market is using that capacity to actually refine the product for everyday use, while also drawing down inventories. With respect to the US, it seems that demand is picking up again necessitating the need for increased production.

But outside the US, the story remains mixed. While we agree that US demand will likely grow back to its pre-pandemic levels, we are not convinced the same will hold true elsewhere in the near-term. In fact, even in Q1, the EIA was forecasting that global oil demand would reach 101.3 million bbl/day, which would be just 400,000 bbl/day more than what was used in 2019. But again, that’s in 2022. Until then, oil demand will likely remain in the mid 90 million range for the balance of 2021 just given how the global economic landscape is evolving. For example, in just the past three months we have a number of countries revise down their 2021 GDP growth assumptions given the rise of second and third waves of COVID-19 in the spring of 2021.

While the IMF has reaffirmed that it plans to keep its global growth forecast at 6%, the risks to the downside are increasing, and not the other way around. India, for example, is unlikely to achieve its initially forecasted 12% GDP growth target, and instead may need to settle for something closer to 8%. Southeast Asia, meanwhile, is now facing another wave of COVID-19 cases. And let’s not forget, base affects should be giving global growth a natural boost given the lower GDP figures in 2020, but that’s not providing the massive tailwind we’d expect. Thus, 2021 aggerate global GDP may still be below 2019.

While GDP growth and oil demand are not one-in-the-same, there is a high degree of correlation between the two. Thus, it’s possible that outside the US, demand may slip, and consequently, global demand could continue to hover at, or just below, 100 million bbl/day for the next year. In the medium to long term, however, it is of course a different story when GDP growth starts to pick up in major oil-consuming emerging markets.

Supply-Demand imbalance skews the potential path of prices lower

Granted, the supply-demand disconnect does not imply that oil prices could collapse. Afterall, OPEC+ could respond very quickly if it does not see demand picking up and opt to either slow down the production increases or extend the timeline. But the potential imbalance does place downward pressure on prices. In fact, spot crude prices have already come off their near-term high of USD 75/bbl, settling around USD 67/bbl. For comparison, before COVID-19, when production and demand were largely in balance and we were not witnessing any shocks on either end, crude hovered around USD 60/bbl and briefly approached USD 80/bbl, albeit momentarily.

Thus, in an era where production is slated to increase back to pre-pandemic levels, but economic headwinds persist, it’s hard to justify crude at USD 75/bbl, or even USD 65/bbl for that matter. A return to the status quo would imply USD 60/bbl, but that would imply just that, the pre-pandemic status quo. Instead, the data we noted above indicates that markets have till now priced in a strong global rebound. That then means the upside is largely capped, whereas the downside potential remains exposed. What could cause upside pressure??A flare up in Middle East tensions, a growth shock to the upside, or OPEC+ completely abandoning its decision from July 18th. But those are somewhat outside the box events.

What could cause downside price pressures?

Global growth continuing to miss its targets, OPEC+ delivering on its goals, or another flare up in COVID cases, which would go back to point about global growth missing its targets. Those all seem far more likely events, at least now. Demand will be far harder to control as it will be a function of global growth. Supply, however, can be easily managed, if geopolitics don’t get in the way. Now though, it seems that OPEC+, combined with US production, and the prospects of an Iran deal could unleash more supply. This is what many countries asked for to ease the global economic recovery. But it also indicates that the oil story is more about supply-side factors. ?Again, we are not trying to forecast prices. But simply noting that the data suggests prices are more likely to stay where they are, or go lower, with less probability supporting an upward trajectory in crude prices.

Please stay tuned for Part 2, which will feature an analysis on the geopolitical tensions between the UAE and Saudi Arabia, which is affecting how OPEC+ is making supply decisions.