Futures markets are sending a strong and unambiguous message that petroleum inventories are already tight and expected to shrink further in the second half of the year and into 2022.

OPEC+ countries are still restricting liquids production by more than 3.0 million barrels per day (bpd) compared with the pre-epidemic levels to cut inventories and raise prices (https://tmsnrt.rs/3wB4XDy).

And U.S. liquids output is also down by more than 1.5 million bpd, according to estimates by the U.S. Energy Information Administration (“Short-Term Energy Outlook”, EIA, June 8).

U.S. shale producers have so far reacted cautiously to the rise in prices, returning earnings to shareholders and cutting debt rather than increasing drilling and production.

Shale producers are adding extra rigs more slowly than in previous recoveries and the total number of active rigs (365) is less than half the number (844-869) the last time WTI prices were at similar levels in 2018.

But the continued rise in prices is signalling the urgent need for more production from one or more of OPEC+, Iran once U.S. sanctions are lifted, U.S. shale firms and the non-OPEC non-shale producers.

Uncertainty about the timing and extent of sanctions relief on Iran helps explain why OPEC+ has taken a cautious approach to lifting production so far despite signs of a much faster recovery in oil consumption.

Intense pressure on the industry as a result of last year’s pandemic and associated price slump received widespread sympathy from consumers and an understanding that prices had fallen unsustainably low and needed to rise.

But prices are now relatively high. If they continue climbing while producers hold down output, the lack of a production response is likely to draw more critical scrutiny from consumers into the market’s operation.

With non-energy commodity prices rising at the fastest rate since the 1970s, and central banks becoming alert to the threat of faster inflation, rising oil prices will soon start to attract more political attention.

PRICE INDICATORS

Front-month Brent futures prices < have risen more than 10% over the last two months as OPEC+ and U.S. shale firms have continued to restrict output even as the United States and European economies have re-opened.

As a result, Brent futures prices have climbed to their highest level since 2018, before the intensifying trade war between the United States and China hit the global economy.

In real terms, the price of the front-month Brent contract has risen to the 67th percentile for all months since 1990, confirming the industry is now well into the expansion phase of the cycle.

Brent’s six-month calendar spread has surged into a backwardation of more than $3.60 per barrel, the 93rd percentile for all trading days since 1990, underscoring that the market is expected to become very tight.

Flat prices and spreads are both reacting to the persistent under-production of petroleum over the last year and decline in inventories of both crude and refined products.

Commercial petroleum stocks in the countries of the Organization for Economic Cooperation and Development (OECD) have already fallen by 300 million barrels or 10% since June 2020.

OECD inventories are now more than 1% below the pre-epidemic five-year average for 2015-2019 and the deficit is expected to persist throughout the remainder of 2021 and 2022.

Position-building by hedge funds and other portfolio investors has accelerated and magnified the increase in futures prices, as investors anticipate an increasingly tight market towards the end of the year.

Physical markets are not yet as tight as their futures counterparts: there are sufficient stocks for now, but availability is expected to deteriorate later in the year.

Dated Brent’s five-week spread is trading in a small backwardation of 35 cents per barrel, which lies in the 65th percentile since 2010.

But the oil market is now well into the upswing phase of the price cycle when more production will be needed to satisfy rapidly recovering consumption.

The longer OPEC+ and shale producers wait before responding, the greater the likelihood prices will climb too high, creating conditions for the next downturn, just as delays in responding to price rises in 2013/14 and 2017/18 created conditions for price slumps in 2014/15 and again in 2019/2020.