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Tapering of cuts by OPEC+ seems to have judged market sentiment correctly

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06 Apr 2021 02:04:58 GMT9
06 Apr 2021 02:04:58 GMT9

It came as a surprise when OPEC+ decided to put more than 1 million barrels per day (bpd) of incremental oil supplies onto the market over the three-month period from May through July. The measure went hand in hand with Saudi Arabia’s unwinding of its 1 million bpd of voluntary production cuts over the same time frame.

It had always been clear that the organization needed to taper the historically high production cuts, which had been decided last spring in the aftermath of an unprecedented demand shock due to the economic impact of the coronavirus pandemic.

Last December, OPEC+ had stipulated that it would gradually unwind its cuts; therefore, barrels were to be released onto the market sooner or later. As vaccination programs had yet to take hold, the organization refrained from pumping more oil. The April 1 decision frontloaded that unwinding more than was generally expected. The Kingdom doubled down on the bullish sentiment, increasing pricing for Asia. What did come as a surprise, but should not have come as such, was how well  markets responded to the news. WTI rose almost 4 percent on the day and Brent was up by 3 percent.

The market reaction proved that the organization had read the market correctly. East of Suez, many economies are powering ahead, with China’s oil demand already exceeding pre-pandemic levels. India will be getting there, too.

Last Friday, the US released its latest unemployment numbers, which again painted a good picture, adding an extra 916,000 jobs in March, bringing unemployment down to 6 percent. This was the best statistic the US Department of Labor has released in seven months. The real laggard is continental Europe, where vaccination programs stalled and rising coronavirus cases led to more restrictions and lockdowns.

Asia and the US proved that reflation is underway, and that oil is the classic reflation trade. Goldman Sachs raised its oil price forecast to $75 per barrel for the second quarter of 2021, and to $80 for the third quarter, which is very optimistic indeed.

OPEC+ was clearly on to a more risk-on market sentiment as vaccination schemes take hold and economies begin reverting to normal. In the last few months, demand has outstripped supply, which is why something had to give sooner or later.

This does not mean, however, that oil markets are totally out of the woods yet. Europe, Brazil and increasingly India, prove that the virus is resilient, can mutate and spread rapidly if vaccination programs are implemented too slowly. However, OPEC+ wisely decided in December that ministers would meet on a monthly basis to ensure flexibility. The next meeting will take place on April 28, just in time to tweak production limits for May and June, should this become necessary.

One of the reasons many analysts remain so bullish is that chronic underinvestment in the oil industry leads to capacity being at a premium. Oil is a long-cycle business. It entails a lot more to turn on the taps than flicking a switch. The investment cycle can take anywhere from three to 10 years from initial investment to production, which means that the industry at large will be reeling from the cuts to their capital expenditures for some time to come.

The US shale space is somewhat different, with shorter investment to production cycles. So far, companies have been cautious when it comes time to drilling more. For one, many smaller producers have been reeling under a credit crunch, and some will not survive. The bigger players want to ensure that there is ample demand before they invest. This being said, the shale space has been good for many surprises over the last decade or so. According to the April 1 rig count by Baker Hughes, the US added 13 rigs during that week.

All of the above supports the thesis that oil is one of the big reflation trades, as the global economy emerges from the pandemic amid huge stimulus packages in OECD countries.

Throwing caution to the wind, therefore, can still not be the strategy as long as the virus is with us. Prince Abdul Aziz bin Salman, the Saudi energy minister, made a very good point when he reiterated the need for flexibility and the ability to tweak OPEC+ responses to market developments in real time.

By Monday midday CET, the oil price had come down by 1.35 percent on the day to $60.25 for WTI, and by 1.30 percent to 63.56 per barrel for Brent. Trading was light, with many markets closed for the Easter holiday break.

• Cornelia Meyer is a Ph.D.-level economist with 30 years of experience in investment banking and industry. She is chairperson and CEO of business consultancy Meyer Resources. Twitter: @MeyerResources

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