After meandering steadily higher for the past week, and completely ignoring the negative newsflow out of the Doha meeting, today oil took an unexpected leg lower to 4-day lows, leaving many stumped: what caused this drop?
The answer, according to Citi, is the realization Saudi Arabia is actually making good on its threat to boost production (recall that just one day ahead of Doha, Saudi deputy crown prince bin Salman said he could add a million barrels immediately) something we noted a month ago in "Why Saudi Arabia Has No Intention To End The Oil Glut."
As Citi's Ed Morse notes, the biggest bear risk to the oil market right now is that Iran’s ramp-up accelerates (which might in fact be happening with recent data indicating that April crude exports are running at ~1.9-m b/d) and then that Saudi Arabia does the same.
This would come as a surprise to many because one argument against the notion that the Saudis would turn on the taps is that "this would require ripping up their marketing playbook which relies on long term contracts with select buyers."
As Citi adds, today’s news that Saudi Arabia is selling a cargo on the spot market to Asia may mark the turning of a dramatic new chapter in the Saudi playbook.
Recall that as we noted in our earlier post on the record demand by Chinese teapot refiners, in the recent surge of imports to Chinese teapot refineries the biggest beneficiaries were the Russians, while Saudi Arabia was the biggest loser. As JPM documented when highlighting the sources of Chinese oil imports:
"Russian imports strong in March at the expense of Middle East. In total, Atlantic basin–sourced crude was 28% of total imports, up from 25% the month prior, while Middle East–sourced crude was 44% of imports, down from 51% the previous month. Russian imports were the second highest on record at 4.6 million tons (up from 4.1 million tons in February), well above Saudi Arabia (4.0 million tons). Russia imports were 14% of total Chinese imports. The strength in Atlantic Basin exports primarily came from Venezuela, Colombia, and Brazil, which were all at or near record high."
Which brings us to today Reuters report that "Saudi Aramco has sold a crude oil cargo to an independent Chinese refinery, its first spot sale to such a buyer in a sign that the world's biggest exporter is trying to expand beyond its state-owned customers in China, a source with knowledge of the deal said.
The 730,000-barrel cargo will be lifted in June from Aramco's storage in Japan's Okinawa prefecture and shipped to China's eastern province of Shandong, the source said.
Which brings us back to Ed Morse who says that "if anyone had a doubt about Saudi Aramco's ability to use its logistical system and spot sales to increase market share, its recent 730-k bbl sale of a cargo to a Chinese teapot refiner in Shandong should lay any doubts to rest."
Not only that, but according to Morse, the Saudis have a clear advantage if they are indeed trying to boost supplies to China to regain market share lost to Russia:
The sale comes from Aramco's leased crude inventory at Japan's Okinawa Island, a clear advantage Aramco has in marketing incremental sales not just into Asia but to Europe and the US as well given Saudi inventories deployed worldwide. What is unusual is that the sale is spot rather than the initiation of a new term contract. The Kingdom has had its sales arms tied behind their backs in competition for market share. For decades the world’s largest exporter has been handicapped by its conservative commitment to term sales based on long term contracts with limited open credit and strict payment terms. That might be great for maintaining the bulk of the ~7-m b/d of Saudi sales but it is a handicap in a world in which lumpy buyers prefer spot sales and where competitors offer a larger amount of open credit extending beyond 30 days to 90 days or even more, in the case of Iran.
And the unpleasant punchline for oil bulls: another 500,000 b/d in production may be about to hit the market.
It looks increasingly likely that the Kingdom is targeting another 0.5-m b/d of sales, bringing its production up to a steadier 11-m b/d or higher as the summer high burn season for crude in power generation reaches its peak and just at the same time that Iran looks like it will be adding 1-m b/d to sales above its pre-January levels.
According to Citi, "11-m b/d of production might be the new normal for the kingdom. This battle to secure market share appears to be the main driver of Saudi oil policy right now as witnessed by the breakdown in the Doha talks and apparent agreement to freeze production at January levels by a large number of oil producers, excluding Iran and the US, earlier this month. This ongoing effort by the Kingdom to secure market share at a price level too low to sustain output in the US, other non-OPEC producers and even marginal cost OPEC countries is the only significant bearish factor on the immediate oil horizon, in our view."
This is not the first time the Saudis have done this: the kingdom's oil marketing arm seems to have employed the same spot sales tactic in increasing market share in Europe at the expense of Russia and perhaps Iraq in late 2015. Spot sales are about the only way the Kingdom can gain new market share in a world in which chunky buyers are interested in securing incremental purchases via spot rather than term arrangements. Saudi Aramco has long shunned spot sales but it remains to be seen whether in the new oil environment, in an effort to gain greater control over market share and market pricing, the Kingdom will move more aggressively to allow resale of its crude and truly re-establish Saudi light crude oil as the global benchmark. With the Saudi Deputy Crown Prince just establishing a new road for transforming the kingdom for a post oil reformed economy, and with his talk of boosting output well above today's level to even 20-m b/d, it's time to think about what the new world oil order will look like and what the role of the world's largest exporter will look like.
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In other words, the rush to capture marginal Chinese market share is now on, and the question is how Russia will respond. The most likely answer: by undercutting Saudi pricing in its ongoing attempts to boost its own rising Chinese market presence.
But the worst news could be not so much the marked boost in production but that Chinese demand, as we documented just a few hours ago, may be about to hit a wall as Chinese teapots are closed for an extened period of time to undergo regular maintenance...
... leaving a world betting on soaring Chinese demand suddenly scrambling what to do with all the excess seaborne oil.