This article was written in collaboration with Homayoun Falakshahi.
The measured and steady approach by OPEC+ to manage the market has effectively put a floor under Brent crude prices around $65/bbl, unless a new covid variant wreaks havoc. Global onshore inventories may well start to level off as we move into 2022 as Chinese buying picks up and higher OPEC+ supplies head to Asia.
Global onshore inventories have drawn down heavily since their peak in June 2020 of 3.8 bn bbls, dropping just over 400 mb to a more than 2-year low. We could, however, be at an inflection point as China is showing signs of renewed buying activity and OPEC+ continues to unwind its production cuts.
Between January and November of last year, China built onshore oil inventories by 166 mb to a record 952 mb, buying unwanted oil at bargain-basement prices over the peak of global pandemic lockdowns. But as oil prices have steadily climbed through 2021, China chose to draw down onshore inventories instead of buying at higher prices. Chinese inventories accordingly dropped 120 mb from their peak in November 2020 to a low of 833 mb in mid-October.
But the recent flat-price drop appears to have encouraged China to buy the dip once again – a tendency we are accustomed to seeing - even in times before the pandemic. It also appears that China is unwilling to let inventories fall below pre-pandemic levels of 800 mb. We are already seeing renewed buying in both rising imports and a rebound in oil inventories. Seaborne imports have rebounded from a multi-year low in October of 8.3 mbd, to 9.3 mbd in November, and 10.4 mbd so far in December, while onshore inventories have climbed 33 mb in the last two months.
Looking ahead, the Lunar New Year and the Winter Olympics provide a bullish case as for why we should see import strength continue. China tends to stock up on crude ahead of the Lunar New Year, while it will likely switch to using both natural gas and diesel for power generation in an effort to reduce pollution from coal-fired plants ahead of the Winter Olympics. Beyond that, as regional demand recovers in East Asia and mobility increases next year, China has plenty of spare refining capacity to boost runs to meet both domestic and regional demand. After all, they added close to 1 mbd of refining capacity in the past couple of years. Given this backdrop, seaborne imports should rise next year to challenge 2020's record pace of 10 mbd, rather than trending similar to this year's lesser 9.6 mbd.
There is still a going concern that China could maintain its bearish influence on the market in 2022. Ongoing lockdowns in China remain very strict. For example, a traveler arriving in China needs to quarantine for a minimum of four weeks and sometimes as much as eight weeks, depending on the city. While it is nearly impossible to quantify the impact of localized lockdowns, we think it likely that over 200 million people have been ordered to stay at home in 2021 (lasting from less than 2 weeks to more than 3 months), providing a significant dent in domestic fuel demand. This is reflected in Chinese highway passenger traffic, which is down 23% year-to-date versus year-ago levels, while also being compared to a very weak baseline. On the flip side, distillate demand is more optimistic. Highway freight traffic is up 18% year-to-date versus year-ago levels, although much of this strength was seen in the first half of the year. Coal/gas to diesel switching appears to have also been underway in the power generation sector already, given the price spikes in coal and natural gas early in the fourth quarter.
The recent rebound in Chinese oil imports comes after it has uncharacteristically been an omnipresent bearish influence on prices in 2021 when in recent years it has persistently been the biggest driver of global import growth. Offsetting Chinese bearishness, OPEC+ has played the counterweight, remaining disciplined and consistently putting back a steady pace of production onto the global market at a time when demand has been undulating and unpredictable.
The group has mostly maintained its harmony through 2021 – aside from a small spat between the UAE and Saudi Arabia in July over reference production numbers the group has proven to be the driving force in preserving market stability, taking a measured and steady approach in managing the market this year.
OPEC+ has not only rebuffed the call to change its tack – be it to raise production further than mandated in October or a pause in November – but is intent on maintaining its momentum and flexibility by adding language to its current message that ‘the meeting remains in session’ for it to be able to change its course at any given moment. By doing so, it has effectively put a floor under prices around $65 for Brent, unless a new covid variant wreaks havoc.
OPEC+ exports have risen strongly in recent months. However, for some countries, the upside potential is limited from here, while some countries are already falling short. Russia, Saudi Arabia, and UAE can add 2.4 mbd based on the agreement, although Russia already appears to be struggling to boost production. We have an OPEC+ production model that takes into account refinery runs, variations in inventories, crude burn, and pipeline data where possible, and we believe that Russian production is at 10.5 mbd, some 500 kbd lower than their reference production number. Based on this model, we think the market is still undersupplied as we move through December, with demand outpacing supply – similar to last month.
While Saudi Arabia and UAE still can increase production and exports, they won’t be able to make up for losses elsewhere. For example, West African nations continue to struggle, with exports 800 kbd lower than in 2019 and 450 kbd lower than in 2020 – led by Angolan exports in November dropping under 1 mbd to their lowest level in decades as a result of a persistent lack of investment and new crude streams coming online.
In terms of what is immediately ahead of us, global oil exports are easing lower in December after rising for four consecutive months to a 19-month high in November of 40.66 mbd. This is the result of supply-led weakness via lower loadings out of West Africa and South America, as opposed to weaker demand for OPEC barrels. Middle East OPEC exports are continuing their ascent this month, with flows favoring Asia once more – and particularly China, which is seeing flows at one of its strongest monthly paces so far this year.
OPEC+ is set to meet on January 4th, at which point Saudi crude will be flowing to Asia after the kingdom hiked its OSPs across all its key grades to the region, with Arab Light crude differentials lifted to their highest in nearly two years. Given the current rising trend and Saudi’s price hike, we should expect ongoing demand strength for OPEC barrels into Asia – a signal of a healthy global market – despite all the uncertainty surrounding Omicron.
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