Bipan hosts Head of Commodity Fundamentals at CIBC NY, Shaun Sherman, to discuss the latest OPEC+ decision and ramifications for markets.
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Bipan Rai: So now is my chance to hold your feet to the fire. What are you expecting in terms of average WTI and Brent prices for this year?
Shaun Sherman: So for this year, we think that a lot of the move is already done, assuming that OPEC does change tact and bring back around point for twenty five million barrels a day.
Bipan Rai: Welcome, everybody, to the second edition of this podcast and the first one under this new name. So going forward, this is the name, FX Factor that you're going to be looking for in the search bar for Spotify, Google or iTunes. I'm your host, Bipan Rai, North American Head of FX Strategy here at CIBC. And with me, I have a special guest from our energy team in New York, Shaun Sherman, Head of Commodity Fundamental Analysis here at CIBC Capital Markets. Now for this podcast, I wanted to get somebody who knows a thing or two about the energy market and can help me internalize what we heard from OPEC+ last week, what came of it, and again, how we should really think about energy prices going forward. This is a market that I'm very much a tourist at when it comes to oil. And of course, but it is important in terms of the pass through to other markets in the macro space, including the one I cover in foreign exchange. So I reached out to Shaun, who's our resident expert here on the trading desk, and he's been very helpful to me in the past. And he's a little bit nervous coming on this podcast, I guess, because you thought, Shaun, that this would be like a Joe Rogan type of deal when we'd be talking for three hours. But really, it's only 15 minutes. Pretty sure the audiences want to hear us speak for that long. But how are you, man?
Shaun Sherman: Good, good. How are you?
Bipan Rai: Not bad, not bad. So again, help me frame this OPEC+ decision. We chatted a bit beforehand going into the meeting about your base case, which was for cuts to be rolled back to around 70 million barrels per day in March and then potentially to 5.8 in June. What happened, man? What changed?
Shaun Sherman: Yeah, we did expect a total of about 1.35 million barrels a day to come back. One million barrels a day of that would have been Saudi Arabia's voluntary cut rolling off. They had signaled they would only keep that on through March, but they changed their mind. And then we expected, especially given the price rally for everyone else to want to add volume, because the market was basically bidding for it. Instead, everything basically got rolled over for a month outside of Russia and Kazakhstan, which once again argued for a small increase in their quotas in line with what they would have gotten if the group had added half a million barrels a day. We had expected this to be a path towards OPEC getting to phase three of their agreement, which called for 5.8 million barrels a day to be kept off the market through April 22. And that would be the extent of the agreement. But instead, going into April, we're going to have basically the same thing offline that we had for March. So the market is going to be incrementally tighter in the near term by about 40 million barrels total.
Bipan Rai: Again, you know, why did the Saudis elect to go slower than originally forecast. Is there a method to the madness that they're looking at? What would you say was the rationale behind the action taken yesterday, or the lack of action, I should say?
Bipan Rai: Well, I would say there is some madness. There's maybe a method to it. The primary thing is the Saudi oil minister, the new one that took over in late 2019, he's shown an affinity for surprises and likes to follow up with press conferences with some colourful phrases. He's told the shorts to make my day. Anyone who thinks they can figure out what I'm going to do is in la la land, whoever gambles on this market will be ouching like hell. So he basically seeks to surprise the market at this point, it seems. But he laid out his reasoning as well. He preached caution about the demand outlook. He says he doesn't care about prices. He cares about the group adhering to the cuts, to the quotas. And he wants to wait until at least inventories are drawn down to the five year average before really acting in a material way. So he's preaching caution, but also likes to provide upside surprises to the market.
Bipan Rai: Ok, I know in the media this got a little bit of airplay, but was there anything, most people would say that day if you cut production, you raise prices up. That potentially brings US shale back online. What are they thinking with respect to that? Are they worried at all about shale or are they more thinking about, you know, the fact that there's going to be more of a focus on profits as opposed to growth in the US shale sector?
Shaun Sherman: Yes. So this is a big bet on their part, one that they're probably going to be right about in the short term at least. But they are once again thinking that shale will not grow at a fast rate. And they've done this at least two other times before and ended up having to cut subsequently. US producers, really the big ones, the majors and the large cap producers have been preaching capital discipline. They found the religion of capital discipline, which has been forced upon them by investors. Any time, at least since last year, and even through earnings calls over the past couple of weeks, that a producer signaled they might increase CapEx, their shares got hit. So that religion is being forced upon them. And obviously, Saudi Arabia is watching, OPEC's watching and they are thinking that they have a window here to capture higher prices without shale responding.
Bipan Rai: Interesting. So the next meeting is set for early April. How does this change things up for that meeting? Are we expecting them to potentially bring those barrels back into production this time around? Or could there be the risk that they delay again?
Shaun Sherman: So Saudi Arabia essentially committed to not bringing back all one million barrels a day if they're cut at once. So I would say base case at this point would be for them to add back half a million barrels a day in May and then the other half in June. But that's not for certain. And with the Saudi minister basically looking at inventories, he might wait for inventories to draw down below the five year average. And in fact, he may not get confirmation that that has occurred until a couple of months after it's happened, just based on delays from, for example, the IEA and reporting their OECD inventories.
Bipan Rai: Right, right. And is there a risk that they could over tighten the market then in the second half of this year?
Shaun Sherman: Certainly, although that's basically going to be to the benefit of them and actually to shale producers as well. It's going to be at the detriment of consumers. So India, already heading into the meeting, had been complaining about prices being too high and now, of course, they're higher. So that has already probably started to hit demand in India because they're relatively price sensitive. And China, not necessarily from liquids demand perspective for gasoline and diesel, but from a crude buying perspective, is likely to reduce the pace of their buying and draw down inventories that they really stockpiled in 2020 until prices are a bit lower. So there will be an impact on demand and on crude buying from prices being higher. But OPEC's betting that nets, they're going to benefit from this.
Bipan Rai: Interesting. So enough about OPEC and OPEC+, let's switch gears and talk a little bit about Iran, which you've pointed out to me in the past is the biggest wildcard for the crude market in 2021. You know, specifically, I guess we're looking at things from a more geopolitical perspective. What's Biden's approach or the least the Biden administration's approach to Iran and how does it differ from Trump's?
Shaun Sherman: Well, the Trump approach was, first of all, get out of the JCPOA, the nuclear deal that was negotiated with Europe and China and Russia. He's called it a bad deal the whole time, which there definitely was some bipartisan support for that line of thinking that it did not do enough to prevent Iran from escalating or being bad actors in the region, even if it did stop them from getting nuclear weapons. The Trump administration was maximum pressure, sanctions on sanctions on sanctions, to basically choke Iran's economy and to get them to come back to the table for a stricter deal. The Biden administration, which he was in the Obama administration that originally negotiated the deal, is seeking to stop Iran from escalating their nuclear program, first of all, and just get them back somewhere in the guidelines of that agreement first before trying to get some sort of political win by adding some additional restrictions to Iran's ballistic missiles or to add consequences for bad acting by their proxies, Iran's proxies on the region.
Bipan Rai: Right. And where we at now with respect to negotiations, it really seems like it's a case of who is going to blink first now right?
Shaun Sherman: Yeah, we're basically nowhere. Both sides have said, you move first, you move first. Europe tried to convene preliminary discussions and Iran basically said, no, we need you to do something first before we'll come to the table. I'm not sure that that's really the position, but the big problem is that Iran has elections this year and currently the reformist government that's in power is probably going to lose power in June and more hardliners are going to be in power. And that's going to probably change the tact of negotiations. That's probably going to prolong things if we get to that point and probably doesn't allow Iran to bring back a material portion of their 1.8 million barrels a day of production that's offline until 2022. So there's really a brief window for the reformist government to try to negotiate with the Biden administration. It's still possible for that to happen. And I think there's already been an increase in Iran's exports through smuggling or just selling more to China or covert movements. But it's looking increasingly likely we won't see big Iran volumes until 2022.
Bipan Rai: Ok, and what would that mean for, say, crude prices in the front view contracts?
Shaun Sherman: Well, it can mean a lot in the front view contracts. I actually think that part of Saudi Arabia's calculus around holding back volume now and trying to rebalance the market faster is maybe some concern about Iran bringing back volumes in the second half and that loosening the market temporarily. So they kind of want to clean things up before that could happen. But on its own, on a long term basis, Iran's capacity is worth probably somewhere around four dollars, five dollars a barrel if it were offline permanently. That's not what we think is going to happen. Their economy is in shambles and they do need to get a deal done of some sort. The hardliners should negotiate eventually. It's probably going to take longer.
Bipan Rai: Right. OK, so let's switch things up again and talk about shale production a little bit more in the US. We know that, or at least we spoke about earlier on this podcast about how higher oil prices should bring some of that production back in the US. But what are the risks view this year? What are you looking at in terms of shale production in the US?
Shaun Sherman: So this year things are more or less set in stone. First of all, there's definitely a lag in between prices and shale response, maybe as long as nine months, but as short as four months if they don't have to drill wells and they complete wells that have already been drilled. But the real thing is that the big producers, like I said, have already committed to CapEx and production plans and they're getting punished from deviating from those. So this year is kind of set in stone. There could be maybe a bit of upside surprise at the very tail end of the year, but that's going to be as a lead up into 2022 when we do expect much more growth at these prices.
Bipan Rai: So now is my chance to hold your feet to the fire. What are you expecting in terms of average WTI and Brent prices for this year?
Shaun Sherman: So for this year, we think that a lot of the move is already done, assuming that OPEC does change tact and bring back around point four to point five million barrels a day incrementally on a monthly basis for the balance of the year, that would essentially normalize their spare capacity back to 2019 levels. And that suggest WTI should be in the upper 60s, Brent, three or four dollars higher than that. But there's big risk to that view. There's mostly upside risk given the lag that Saudi Arabia is acting with. They're being reactionary to fundamentals and inventories rather than looking forward. That suggests an overshoot is quite possible. So in the early 2000s, backwardation between the front and, say, the very back of the curve got up to 40 to 50%. So if you use that sort of level, then you can get WTI around eighty dollars.
Bipan Rai: Eighty dollars. Wow, I mentioned this earlier in this podcast, I mean that matters for a market like mine, because, again, for a lot of currencies that I follow, one of the key inputs is what's happening in the commodity space. And again, WTI at around sixty five dollars per barrel, if I run a simple regression with that of the Canadian dollar, I mean that portends the dollar CAD trading closer to one twenty five. If we're talking about WTI, say closer to eighty dollars, then you know that switches things up. Of course, you know oil isn't the only determinant of the way the currencies like the Canadian dollar trade. Nonetheless, I mean that's one of the reasons in the near term why we, at least on the FX side, continue to like Canadian dollar on the cross is. I wouldn't go so much to say that dollar CAD is going to remain pressured for a while because we do see some potential for a big dollar to do well into the medium term. But certainly, I mean, if I look at the Canadian dollar versus the sterling and other currencies. The euro is another example that there is some scope for some outperformance there. And again, based on what we've heard from Shaun today, certainly there are more upside risks to oil and we need to consider that from an FX perspective as well. That pretty much wraps up everything that I had to say with respect to FX and all the questions that I had to ask Shaun. Shaun, anything else that you're looking at? Anything else that we should be mindful of?
Shaun Sherman: I would just say that we could get a spike to 80, but Cal 22 next year, once shale starts responding, should bring prices back into this low 60s type range for WTI. It should be just a short term overshoot. But shale relief has found a long term religion. Then things can be different. Things could be higher on a more sustained basis.
Bipan Rai: Absolutely. That dovetails nicely with what we're expecting dollar CAD to do over the long term beyond 2021 as well. So that suits, that suits, Shaun, thanks again for joining us today. And of course, if any of our listeners have any questions with respect to the crude market or the FX market, please feel free to reach out. Again, we're easy to get in touch with. And that's it for this episode. We'll be back soon with potentially an outlook over China and the annual MPCC meeting that started last week and has continued into this week. We'll have my colleague Patrick Bennett on to speak about that in the next episode. But for now, thanks everyone for joining us and we'll see you next time. Cheers.
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