Saudi Arabia successfully parlayed crude to three-week highs over $100/b on Aug. 22 but left many unsure if the output cut warning was fueled more by a desire to put a floor under prices, preempt Iran's return to the market, or a genuine alarm over recent market volatility.
Raising the possibility of an OPEC+ production cut, Saudi energy minister Prince Abdulaziz bin Salman blamed a "disconnect" between the futures and physical oil markets and voiced concern that prices are detached from demand/supply fundamentals. The resulting volatility, he said, is damaging the oil market's key function of providing reliable price signals.
His surprise move quickly sparked a chorus of supporting comments from OPEC+ producers equally vexed that the oil market is getting misled.
Although rare in its delivery, the Saudi minister's comments are not out of line with a recent theme of OPEC+ disappointing US-led calls for more production to rein in record high pump prices.
In early August, the producer group surprised markets by agreeing to only a 100,000 b/d quota increase in September over August, citing ongoing economic headwinds and COVID-19 slowdowns in China. A week later, OPEC's new secretary general suggested the 20% selloff in crude futures since June over fears of slowing consumption in China was overdone.
But finger-pointing at a fundamental "disconnect" between physical and futures oil prices seems a stretch.
There has certainly been a more exaggerated differential between physical and paper markets in recent months. Platts Dated Brent physical crude benchmark traded at an average premium of $7/b to ICE Brent front-month futures during June and July, helped by the shut-in of most of Libya's light sweet crudes.
But the price benchmarks returned close to parity on Aug. 18, as resuming Libyan output and surging US exports swollen by SPR stock releases eased supplies of light sweet crudes into the region and narrowed the backwardated futures market.
Even then, some disconnect between the key global paper and physical crude benchmarks is already built into their structure. Dated Brent represents the physical spot value of North Sea crude loading 10 days to a month ahead, while front-month ICE Brent futures is a financial contract for delivery two months forward. All things being equal, Dated Brent will trade higher than ICE Brent in a backwardated market but will switch under a contango price structure.
Volatility threat
The Prince's appeals for output cuts to tame rampant price volatility may hold more water.
Scared off by the soaring costs of hedging against buying physical oil flows, trading activity slumped to a seven-year low in July.
At the start of August, open interest in Brent crude futures stood at its lowest since mid-2015. Although rising in the week to Aug. 16, open trading positions remain well below historical norms. Prince Abdulaziz said this "extreme" volatility has made the cost of hedging and managing risks for physical oil markets prohibitive.
He has a point. High price volatility also damages broader business confidence, delays capital spending, and can stall upstream capacity planning.
Nevertheless, some market watchers take a more nuanced view of Saudi Arabia's motives for the cut threat.
Noting that the current 30-day realized Brent volatility is only 4 percentage points higher than year-ago levels of 44%, Standard Chartered bank thinks the Prince's rationale is on thin ice.
"When oil ministers talk of volatility sometimes they just mean falling prices," Standard Chartered said in a note. "We think that ministerial concerns about volatility are primarily straightforward appeals for higher prices."
Weakening oil demand signals in recent months, not futures price speculation and low volumes, have been the key driver of prices, the bank said.
Quota conundrum
OPEC kingpin Saudi Arabia has no shortage of motives to want higher prices.
OPEC+ is having to contend with the prospect of renewed exports from member Iran. Tehran could add about 1 million b/d within three months of an agreement with the US, according to Platts Analytics, with volumes rising to 1.4 million b/d of extra oil by the end of 2023.
At the same time, EU sanctions are set to squeeze supplies from OPEC+ member Russia over its invasion of Ukraine.
"The comments likely signal a cut if the US reaches a nuclear deal with Iran, particularly after OPEC+ raised September quotas by 100,000 b/d as a gesture to President Biden," said Shin Kim, head of oil and gas supply at Platts Analytics. "It also raises the odds that OPEC output will fall from unsustainable September highs in Q4, with or without an official cut, while quotas are likely to fall from currently elevated levels when the current deal is extended beyond its year-end expiration."
Even if OPEC+ does push through cuts to its production quotas at its next meeting, it may mean little in terms of actual barrels flowing to the market.
Hobbled by thinning spare capacity, OPEC+ has been undershooting its quota by a bigger margin. The group is pumping 2.8 million b/d less than its headlines targets, with many producers unable to keep ramping up flows.
On that basis, a quota cut could amount to little more than a chance to realign quotas that are running way ahead of actual production.
OPEC+ has to tread a thin line on future output quotas when the group is next scheduled to meet Sept. 5.
A cut would underpin oil prices in the event of a marked demand slowdown. But overshooting on production curbs risks sending oil prices spiraling back towards $150/b, turning the screws on the global economy and inviting a recession-related demand slump the producer club will be keen to avoid.