We are almost a month past the announcement by the OPEC nations that they had informally agreed to a production cut at a meeting in Algiers, and almost a month away from the formal meeting where OPEC will convene to formalise the agreement. And already we are seeing fractures within the coalition, interspaced between some encouraging news.
On one hand, Russia’s Vladimir Putin appeared to back the production freeze at a conference in Istanbul, and Saudi Arabia has recently commented other non-OPEC countries have expressed willingness to negotiate a pan-global production cut. If this happens, markets will rally, crude prices will rise and everyone will be better off all around. Even the small cut of up to 1 mb/d proposed by OPEC had a material effect, offset by prices that breached US$50/b when it was announced. A more significant cut, say to the tune of 3-4 mb/d, would do much to alleviate the global supply glut, benefitting all players in the industry with higher prices.
As wonderful as that sounds, it will not happen. Within OPEC itself, three members states – Iraq, Venezuela and Iran – are already disagreeing on the data the organisation uses to calculate the block’s output. They claim that that discrepancies in individual member output figures distort OPEC’s total monthly production, which in turn will distort the planned cuts, which will be apportioned across all members except for Libya, Nigeria and Iran, which have exemptions. It speaks poorly of the trust the organisation has internally if its own data cannot be trusted, but OPEC is now an organisation glued together by mere vague history instead of a common goal that it had in the 1970s.
Externally, Saudi Arabia might talk big about Russia and other major
producers like Canada, Norway, Brazil and the US joining the freeze, but it is
a pipe dream. These producers might make overtures to support a cut, but unless
a binding agreement is signed, have no responsibility to adhere to any cuts.
And even if binding quotas are agreed on, they can easily be flouted, just like
in OPEC itself.
This is a classic example of game theory at work – the economic
theory that players within the game will tend to look out for their own
interests, instead of the interests of a common group. This is made more
complicated by the fact that there are two sets of games being played – within
OPEC, and between OPEC and non-OPEC countries.
If the OPEC countries could just cooperate, gains would be shared by
all. But there is too much temptation to ‘cheat’ for greater individual gains –
exacerbated by the exemptions for Nigeria, Libya and Iran – thereby causing
losses for all. And even if OPEC could get its own house in order, it is still
in a game with the rest of the world. Russia might say benign words, but would
be more than happy to pump more oil to steal market share from under their
noses. And that’s saying nothing of countries like the USA and Canada, where
free market forces will conspire to raise supply in response to a rise in
prices, thereby pushing prices down again. We have already seen this in the US,
where the number of operating oil and gas rigs has risen to its highest level
in more than a year, adding new rigs 15 out of the last 16 weeks.
OPEC and non-OPEC producers know this, and more importantly, the
market knows this; which is why prices have barely budged from their new level
in the low US$50/b range. Here it will stay, unless by some miracle, all
players in the industry could be brought in line for the benefit of all,
instead of gains of a few. And in the end, this episode of OPEC will be nothing
more than mere sound and fury, signifying nothing.
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It was shaping up to yet another dull OPEC+ meeting. Cut and dry. Copy and paste. Rubber-stamping yet another monthly increase in production quotas by 432,000 b/d. Month after month of resisting pressure from the largest economies in the world to accelerate supply easing had inured markets to expectations of swift action by OPEC and its wider brethren in OPEC+.
And then, just two days before the meeting, chatter began that suggested something big was brewing. Whispers that Russia could be suspended made the rounds, an about-face for a group that has steadfastly avoided reference to the war in Ukraine, calling it a matter of politics not markets. If Russia was indeed removed from the production quotas, that would allow other OPEC+ producers to fill in the gap in volumes constrained internationally due to sanctions.
That didn’t happen. In fact, OPEC+ Joint Technical Committee commented that suspension of Russia’s quota was not discussed at all and not on the table. Instead, the JTC reduced its global oil demand forecast for 2022 by 200,000 b/d, expecting global oil demand to grow by 3.4 mmb/d this year instead with the downside being volatility linked to ‘geopolitical situations and Covid developments.’ Ordinarily, that would be a sign for OPEC+ to hold to its usual supply easing schedule. After all, the group has been claiming that oil markets have ‘been in balance’ for much of the first five months of 2022. Instead, the group surprised traders by announcing an increase in its monthly oil supply hike for July and August, adding 648,000 b/d each month for a 50% rise from the previous baseline.
The increase will be divided proportionally across OPEC+, as has been since the landmark supply deal in spring 2020. Crucially this includes Russia, where the new quota will be a paper one, since Western sanctions means that any additional Russian crude is unlikely to make it to the market. And that too goes for other members that haven’t even met their previous lower quotas, including Iraq, Angola and Nigeria. The oil ministers know this and the market knows this. Which is why the surprise announcement didn’t budge crude prices by very much at all.
In fact, there are only two countries within OPEC+ that have enough spare capacity to be ramped up quickly. The United Arab Emirates, which was responsible for recent turmoil within the group by arguing for higher quotas should be happy. But it will be a measure of backtracking for the only other country in that position, Saudi Arabia. After publicly stating that it had ‘done all it can for the oil market’ and blaming a lack of refining capacity for high fuel prices, the Kingdom’s change of heart seems to be linked to some external pressure. But it could seemingly resist no more. But that spotlight on the UAE and Saudi Arabia will allow both to wrench some market share, as both countries have been long preparing to increase their production. Abu Dhabi recently made three sizable onshore oil discoveries at Bu Hasa, Onshore Block 3 and the Al Dhafra Petroleum Concession, that adds some 650 million barrels to its reserves, which would help lift the ceiling for oil production from 4 to 5 mmb/d by 2030. Meanwhile, Saudi Aramco is expected to contract over 30 offshore rigs in 2022 alone, targeting the Marjan and Zuluf fields to increase production from 12 to 13 mmb/d by 2027.
The UAE wants to ramp up, certainly. But does Saudi Arabia too? As the dominant power of OPEC, what Saudi Arabia wants it usually gets. The signals all along were that the Kingdom wanted to remain prudent. It is not that it cannot, there is about a million barrels per day of extra production capacity that Saudi Arabia can open up immediately but that it does not want to. Bringing those extra volume on means that spare capacity drops down to critical levels, eliminating options if extra crises emerge. One is already starting up again in Libya, where internal political discord for years has led to an on-off, stop-start rhythm in Libyan crude. If Saudi Arabia uses up all its spare capacity, oil prices could jump even higher if new emergencies emerge with no avenue to tackle them. That the Saudis have given in (slightly) must mean that political pressure is heating up. That the announcement was made at the OPEC+ meeting and not a summit between US and Saudi leaders must mean that a façade of independence must be maintained around the crucial decisions to raise supply quotas.
But that increase is not going to be enough, especially with Russia’s absence. Markets largely shrugged off the announcement, keeping Brent crude at US$120/b levels. Consumption is booming, as the world rushes to enjoy its first summer with a high degree of freedom since Covid-19 hit. Which is why global leaders are looking at other ways to tackle high energy prices and mitigate soaring inflation. In Germany, low-priced monthly public transport are intended to wean drivers off cars. In the UK, a windfall tax on energy companies should yield US$6 billion to be used for insulating consumers. And in the US, Joe Biden has been busy.
With the Permian Basin focusing on fiscal prudence instead of wanton drilling, US shale output has not responded to lucrative oil prices that way it used to. American rig counts are only inching up, with some shale basins even losing rigs. So the White House is trying more creative ways. Though the suggestion of an ‘oil consumer cartel’ as an analogue to OPEC by Italian Prime Minister Mario Draghi is likely dead on arrival, the US is looking to unlock supply and tame fuel prices through other ways. Regular releases from the US Strategic Petroleum Reserve has so far done little to bring prices down, but easing sanctions on Venezuelan crude that could be exported to the US and Europe, as well as working with the refining industry to restart recently idled refineries could. Inflation levels above 8% and gasoline prices at all-time highs could lead to a bloody outcome in this year’s midterm elections, and Joe Biden knows that.
But oil (and natural gas) supply/demand dynamics cannot truly start returning to normal as long as the war in Ukraine rages on. And the far-ranging sanctions impacting Russian energy exports will take even longer to be lifted depending on how the war goes. Yes, some Russian crude is making it to the market. China, for example, has been quietly refilling its petroleum reserves with Russian crude (at a discount, of course). India continues to buy from Moscow, as are smaller nations like Sri Lanka where an economic crisis limits options. Selling the crude is one thing, transporting it is another. With most international insurers blacklisting Russian shippers, Russian oil producers can still turn to local insurance and tankers from the once-derided state tanker firm Sovcomflot PJSC to deliver crude to the few customers they still have.
A 50% hike in OPEC’s monthly supply easing targets might seem like a lot. But it isn’t enough. Especially since actual production will fall short of that quota. The entire OPEC system, and the illusion of control it provides has broken down. Russian oil is still trickling out to global buyers but even if it returned in full, there is still not enough refining capacity to absorb those volumes. Doctors speak of long Covid symptoms in patients, and the world energy complex is experiencing long Covid, now with a touch with geopolitical germs as well. It’ll take a long time to recover, so brace yourselves.
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