Oil and Copper Trends Part 1: Supply and Demand

This article originally published in August 2021.

 

Recent decisions by the Organization of the Petroleum Exporting Countries (OPEC), as well as an increase in demand and geopolitical events are impacting oil and copper. We believe these long-term trends could result in oil and copper pricing moving in opposite directions.

 

Historically, both commodities have been positively correlated. But the relationship may be breaking down due to structural changes in the global economy.

 

Oil is an important piece to the global economy. Many nations depend on it as either exporters or importers. Fluctuations in the price of oil can dramatically affect each nation’s current account and fiscal health. In addition, oil can be a significant contributor to inflation and inflation expectations.

 

As with oil, many merging markets are wholly dependent on copper. So, this means it’s affected by geopolitical events.

 

Oil prices collapsed in the summer of 2020, reaching a multi-year low of $32 a barrel. This was due to COVID-19, as no one was driving or flying. However, even before economies began to heal, prices started to turn around – especially towards the end of 2020 and in early 2021 – because of potential economic expansion and a post-COVID-19 global rebound.

 

Despite a brief respite in prices in early March, prices continued to rise throughout the spring of 2021. This is when prices reached a multi-year high of $75 a barrel.

 

The rise in prices was mostly supply-led, given OPEC+ cut production during the pandemic. Specifically, OPEC+ wanted to cut cumulative production by 10 million barrels a day, which was eventually curtailed to about 5.8 million barrels a day.

 

The cuts held for most of 2021. And even though actual demand hasn’t risen, the prospects of rising demand as economies opened, coupled with the lower production by OPEC+, resulted in sharp rises in price during the first half of 2021.

 

Consequently, large oil importing nations began to voice their concerns to OPEC+ members about the sudden rise in prices. As noted, economic growth didn’t firmly take hold with many countries still vulnerable to economic shocks, particularly emerging and frontier markets. Many of which lacked 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 wouldn’t 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 barrels a 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 increases in 2022 – arguing that baselines, or 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. In percentage terms, Saudi Arabia’s production and dollar inflows remained relatively high compared to smaller countries.

 

In the run up to the July 18 meeting, baselines were discussed and amendments agreed to. OPEC+ announced that UAE’s quota would increase from 3.16 million barrels a day to 3.5 million, which is still below the desired 3.8 million. 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 150,000 barrels a day to 2.959 million barrels a day and 4.803 million barrels a day, respectively. Algeria and Nigeria will not see any baseline increases.

 

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

 

At the July 18 meeting, OPEC+ essentially signaled that production will ramp up – and quite aggressively. The Russia case shows that the decision making is more political than practical, which then raises the risk that OPEC+ may overshoot actual demand.

 

With the 400,000 barrels a day increase over 16 months, total OPEC+ production is poised to increase by 6.4 million barrels a day, exceeding the COVID-19 cut, which was 5.8 million barrels a day.

 

If the U.S. and Iran work out a new nuclear deal, they could add another 2.3 million barrels a day into the markets. So, by 2023, it’s possible that global crude supply will be much higher than in 2019.

 

We also shouldn’t forget about U.S. capacity. The latest EIA data shows us that domestic U.S. production hit 1.4 million barrels a day, which is nearly back to pre-pandemic levels. In contrast to OPEC+, U.S. capacity has already scaled back up. It’s possible that production ramps up even further, back to the early 2020 peak of 13 million barrels a day.

 

So, what does this mean? Prior to the OPEC+ announcement, global production was forecasted to hit 97 million barrels a day in 2021 and 102 million barrels a day in 2022. But after the announcement, and with the potential Iran deal, we could see this number increase to about 110 million barrels a day in 2022.

 

It’s clear that supply has rebounded in some markets, like the U.S. And it’s set to rise in others, like the UAE and Saudi Arabia.

 

In the U.S., demand is rising. EIA data reveals that U.S. imports are around 6.2 million barrels a day, largely where the number was in 2020 during COVID-19. But this doesn’t imply that U.S. demand is weak. We know that U.S. production grew, negating the need for more imports. A key data point to consider is that crude oil supplied to refineries rose to 16.1 million barrels a day in July 2021, which is 2 million barrels a day more than July 2020. So, demand for refined goods has grown tremendously.

 

Crude oil stockpiles fell to 437 million barrels a day in 2021, compared to 531 million barrels a day in 2020. So, clearly there was a drawdown in inventories taking place. So, not only is the U.S. ramping up production, the domestic market is using that capacity to actually refine the product for everyday use, while also drawing down inventories. The increase in demand is requiring the need for increased production.

 

Outside of the U.S., it’s a mixed story. While we agree that U.S. demand will likely grow back to its pre-pandemic levels, we’re not convinced the same will hold true elsewhere in the near-term. In fact, in Q1 of 2021, the EIA forecasted that global oil demand would reach 101.3 million barrels a day, which would be about 400,000 barrels a day more than what was used in 2019.

 

While the IMF has reaffirmed that it plans to keep its global growth forecast at 6%, risks to the downside are increasing. 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 that base effects 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. So, 2021 aggregate global GPD may still be below 2019.

 

While GDP growth and oil demand are not one in the same, there’s a high degree of correlation between the two. It’s possible that outside the U.S., demand may slip, which would mean global demand could continue to hover at, or just below, 100 million barrels a day for the next year. In the medium to long term, it’s a different story when GDP growth starts to pick up in major oil-consuming markets.

 

The supply-demand disconnect doesn’t imply that oil prices could collapse. After all, the OPEC+ could respond very quickly if it doesn’t see demand picking up and opt to either slow down the production increases or extend the timeline. The potential imbalance does place downward pressure on prices. In fact, spot crude prices have already come off their near-term high of $75 a barrel, settling around $67 a barrel. For comparison, before COVID-19 when production and demand were largely in balance and we weren’t witnesses any shocks on either end, crude prices hovered around $60 a barrel and briefly approached $80 a barrel – though this was just momentarily.

 

In an era where production is slated to increase back to pre-pandemic levels, but economic headwinds persist, it’s hard to justify crude prices at $75 a barrel or even $65 a barrel. A return to the status quo would imply $60 a barrel. Instead, the data we noted above indicates that markets have priced in a strong global rebound. That then means the upside is largely capped, whereas the downside potentially 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 18. Those are, however, somewhat outside the box events.

 

Global growth continuing to miss its targets, OPEC+ delivering on its goals or another flare up in COVID-19 cases could cause oil prices to decline. Those all seem far more likely events, at least for 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 U.S. 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’re not trying to forecast prices. We’re simply noting that the data suggests that prices are more likely to stay where they are, or go lower, with less probability supporting an upward trajectory in crude prices.