Global oil output is being hit by expanding U.S. sanctions and other unplanned disruptions which, in an echo of market conditions around five years ago, are pushing prices higher in the short term but also setting the stage for the next slump.
Unplanned factors reduced global production by 2.8 million barrels per day in March, down from 3.3 million bpd in February, but up from 1.8 million bpd a year earlier, according to the U.S. Energy Information Administration (EIA).
Disruptions among members of the Organization of the Petroleum Exporting Countries (OPEC) reached 2.49 million bpd in March, double the same month last year.
In recent months, OPEC and total disruptions have been running at the highest levels for almost three years and near some of the highest in a decade.
And the EIA figures do not include Venezuela, where output has been erratically declining and too variable to define a “normal” undisrupted level. Nor do they take into account the potential impact of renewed fighting in Libya, which could upset production and exports in the next few months if it intensifies.
The figures therefore understate the extent to which involuntary production cuts – actual and threatened – have caused the oil market to tighten in recent months.
Sanctions and unplanned problems can help make Saudi Arabia’s role as swing producer more effective by simplifying co-ordination with other producers and reducing the risk of cheating.
But unplanned problems can also cause the oil market to overtighten temporarily, pushing prices higher and masking underlying imbalances between production and consumption, contributing to a subsequent slump.
The recent sudden tightening bears many similarities to events in 2013 and early 2014 – which paved the way for a slump in late 2014 and through 2015.
LESSONS FROM 2014
In 2013/14, U.S. sanctions on Iran, as well temporary disruptions – some actual, others threatened – caused by fighting in Libya and the advance of Islamist fighters across northern Iraq helped keep prices well above $100 per barrel.
Saudi Arabia and other OPEC members with spare capacity were slow to respond, insisting the market remained adequately supplied and prices were not too high.
But hedge funds and other money managers boosted their bullish net long position in crude futures and options to 626 million barrels in late June 2014, up from 367 million six months earlier, accelerating the price increase.
And production problems and high prices fuelled the final stages of the first frenzied U.S. shale drilling boom, causing output to surge, while dampening consumption growth.
Temporary disruptions thus masked the underlying shift in the market balance, so that once problems were resolved prices slumped later in 2014 and in 2015.
Fast forward to late 2018 and early 2019, and the market backdrop again features U.S. sanctions and fighting in Libya, as well as a range of smaller problems.
Relatively low oil prices in 2018 encouraged the U.S. government to impose aggressive sanctions on oil exports from Venezuela and Iran in a bid to topple leaders viewed as hostile.
But the market has tightened much more quickly than seemed probable at the end of last year.
Unplanned disruptions have made scheduled cuts by Saudi Arabia and its allies in the expanded OPEC+ group more effective, shifting the oil market outlook from overproduction to under-supply.
In fact, involuntary production problems have contributed around half of all output cuts achieved by OPEC.
In response, hedge funds have boosted their net long position in crude to 600 million barrels from 243 million at the start of January, accelerating the rise in spot prices and the shift to backwardation.
As a result, front-month Brent prices have risen by almost $21 per barrel (42 per cent) since late December while the six-month futures curve has swung into a sharp backwardation of more than $2 per barrel.
If Washington tries to toughen sanctions on Iran and Venezuela further in the next few months, or the fighting in Libya worsens, the market will become even tighter in the second half of 2019.
So far, Saudi Arabia and its allies in OPEC+ have been non-committal about how much they are prepared to increase output and at what price level to offset losses from other producers.
But the more the market tightens in the near term, and the higher prices rise, the larger the eventual correction is likely to be.