Nodding Donkey

OPEC+ Meeting - 4th November

What are possible outcomes and what is the market telling us? 

26th October 2021

OPEC’s July 2021 meeting was one of the most interesting in years with its two-week impasse, and that took many by surprise. Eventually, OPEC+ agreed to a 400,000 BPD increase each month until at least April 2022 to phase out existing production cuts of 5.8 mbpd. 

The lead up to next month’s meeting sees oil up almost 100% YTD, demand has bounced back but supply still struggling given lack of investment over the last 12 years or so. The US is concerned about the rise in oil prices and its inflationary impact, whilst OPEC+ are wary of any Coronavirus spikes as the Northern Hemisphere heads into winter and Russia’s view is oil demand tends to ease during the fourth quarter.  

The chart below displays the OPEC+ external-breakeven oil price estimate plotted against the current OPEC basket price of $83/bbl. The blue bars represent the price at which each country balances its current account to zero, please note that it doesn’t include the budgeted fiscal needs (a higher oil price is required for that). It is therefore clear that the countries on the right-hand side of the chart, plotting below the current oil price, would benefit most from any production increase at the next meeting.  This chart could be a key problem factor for the next meeting, as in July the UAE argued for a baseline increase.  

OPEC Breakeven Level

OPEC+ meeting outcome scenarios: 

1 Reduction in production: 

This is highly unlikely given the meteoric increase in prices and the resulting geopolitical pressure to increase production from the US and other countries. However, what is possibly more important is many of the OPEC+ countries would not be keen at this juncture with a seemingly well-supported oil price environment there simply isn’t the need for cuts in their view. The only scenario where cuts occur is in a Covid-surge lockdown resulting in a demand destruction scenario of Q2 2020 and an emergency OPEC+ coordination.  

No change 

The base case view, this is the most likely outcome given OPEC+ caution to not impact the recovery in the oil price to what it ultimately sees as a reasonable level. Given the stepped increase agreed in July, referred to above, it is the most probable favoured outcome for Saudi Arabia. OPEC+ have confirmed that this is their intended path on the 4th October, despite other countries request to increase production. With supply falling well below demand, this still results in a volatile but steady uptrend in oil prices, towards 90 USD/bbl. 

Higher Baseline 

Probably the largest issue for this next meeting will be internal arguments from individual OPEC+ countries requesting an increase in their baselines  - this presents the wildcard for the meeting, and certainly a key factor in the heavily debated and delayed outcome in July. The breakeven oil price above highlights the countries most likely to request an increase in their share. The breakeven chart suggests a very contrary problem, for example, UAE was keen for a production increase in July, an understandable request given their breakeven oil price and their investment cycle in oil over the last decade. We feel the question of oil demand destruction resulting from high prices (and not a covid surge), as has been partially witnessed in Natural Gas recently due to the surge in power/natural gas markets seems less likely in oil due to 1) the related oil/coal substitution factor for generating power and 2) the difficulties associated with ICE fuel substitution in the transport sector and refined product consumption. Any increase would likely be very limited 0.5 mbpd or less, which still results in a Q4 market that is undersupplied, causing price pressure to remain stable to upward.  

Price/volume War 

Given the implied weakness in prices this would induce and the effectiveness of the OPEC+ strategy, in their view, this therefore seems a low probability of occurring.  

If a new impasse, as in July, leads to an outright price war, we assume that the main OPEC+ producers return to Apr-20 production levels for a quarter and ultimately agree to scenario 2 or 3 above. This would represent up to a $10/bbl downside in prices. However, the impact is more limited compared to April last year given the large current supply-demand deficit.  

What does the Option market strike price traded highlight?  

WTI Call Strikes

Frequency distribution of WTI Call Options open interest (OI) in WTI Option contracts from Dec21 to May22 inclusive, the red font numbers are the total open interest in each Strike 10 USD bucket. In the last few weeks, Strikes at 180 and 200 USD/bbl have traded, this is remarkable given spot is currently trading at 83 USD/bbl.  

The WTI Call Options market provides some insight into the market sentiment above and below current futures price levels.  In the last weeks a thin tail of heavily Out-The-Money (i.e. higher than current market price) Options have traded – see the $180 Call Option open interest – 3.2 Mbbl in total at 180 USD strike. Levels such as these have not been seen since the late 2008 mega-rally. This Option trade detail is no crystal ball to the eventual future price move (if only it was!), it does highlight the views of some market participants that there is a growing price ‘tail risk’ for a very elevated level between 100-230 USD/bbl! It is most likely resulting from speculative fund trades, taking length in the form of low-cost premium ‘one-way’ Option bets especially at the upper strike prices >150 USD/bbl. However, at the lower 100 USD plus strikes this could be both funds and end-consumer hedges trading – the market is anonymous so this is only a ‘guesstimate’. It does make sense given many end-consumer hedgers, such as airlines, are now realizing the benefits of paying premiums for an Option hedge strategy, instead of the old-style swaps-are-cheaper approach but can lead to unmanageable negative swap margin calls, just as in 2020. Naturally of interest is the bulk of the distribution of all Dec21 to May22 Call Option strikes fall between 100 and 50 USD/bbl. But it is important to note that these have been traded over time and reflect the general rally from 35 – 80 over the last 12 months or so.  


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