The countries of OPEC, once all-powerful in determining oil prices, besieged by infighting – have agreed to their first production freeze in eight years. After many aborted attempts to implement a supply cut, many were skeptical that this latest attempt would succeed. It certainly was a rocky road getting here; the cut was informally agreed in September, and very public outcries by Iran, Iraq, Libya and Nigeria cast doubt on OPEC’s ability to whip its members in line.
After the classic display of Game Theory over the past two yeas, OPEC will reduce its output by 1.2 mb/d by January, confirming OPEC’s intention to stick to the 32.5 mb/d level agreed in Algiers two months ago. More importantly, the agreement extends beyond OPEC, with non-OPEC nations also agreeing to implement cuts, including Russia.
The test of this will be actually implementing it, which is the harder portion of the equation. Nigeria and Libya are exempted from the cuts as they recover from infrastructure damage inflicted earlier this year, but Saudi Arabia, Iran and Iraq have all been given quotas. In particular, Iran has put aside its squabbling with Saudi Arabia to agree to capping its output at 3.8 mb/d, while Saudi Arabia will reduce its production by almost 500 kb/d, the UAE by 140 kb/d and Kuwait by 130 kb/d. Indonesia has requested a suspension of its OPEC membership (only two years after being re-admitted) as production cuts conflict with the country’s urgent need to raise its crude production. Saudi Arabia and its Gulf allies have generally stuck to their quotas in the past, but many other OPEC members haven’t. This will be a constant problem, which may undermine the whole integrity of the agreement.
But thus far the market seems to think OPEC will stick to the plan, sending Brent and WTI crude above the US$50/b mark, the highest since the OPEC Algiers plan was first announced.
Crucially, the plan also includes participation from non-OPEC members. Exactly what this entails is unknown beyond a vague statement that non-OPEC members are expected to reduce production by some 600 kb/d, with Russia decreasing by 300 kb/d (‘conditional to technical ability’, of course). These cuts are non-binding, and again, the harder part after herding the cats together to agree is actually implementing the plan. OPEC’s talks with non-OPEC producers continues on December 9, and meeting again next May to monitor progress. Analysts at Deutsche Bank said the deal isn’t enough to change the oil market outlook. The bank is skeptical that the full reduction will be realized, especially from non-OPEC countries. Analysts said oil traders would watch the agreement warily in the coming weeks.
Rising oil prices in the wake of OPEC’s production cut could hit demand from Asia’s emerging energy consumers, where weakening currencies have already led to higher prices. Since oil is priced in dollars, it makes crude more expensive in local currencies that have weakened against the greenback. China and India, the world’s second- and third-largest oil consumers after the U.S., have each seen declines in their currencies versus the U.S. dollar in recent weeks. However the beleaguered Asian oil industry could benefit from OPEC’s decision to cut production
But we are certainly in more positive territory than we were yesterday. OPEC has agreed to a supply freeze. Most would have dismissed this as a Yeti sighting, but it actually has happened. The nuts and bolts of enforcing it will now begin, and there are plenty of ways this house of cards could tumble down, but as it stands now, 2017 looks to be a better year for oil than 2016. Which can only be a good thing for you and me.
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Supply chains are currently in crisis. They have been for a long time now, ever since the start of the Covid-19 pandemic reshaped the way the world works. Stressed shipping networks and operational blockages – coupled with China’s insistence on a Covid-zero policy – means that cargo tanker rates are at an all-time high and that there just aren’t enough of them. McDonalds and KFCs in Asia are running out of French fries to sell, not because there aren’t enough potatoes in Idaho, but because there aren’t enough ships to deliver them to Japan or to Singapore from Los Angeles. The war in Ukraine has placed a particular emphasis on food supply chains by disrupting global wheat and sunflower oil supply chains and kicking off distressingly high levels of food price inflation across North Africa, the Middle East and Asia. It was against this backdrop that Indonesia announced a complete ban on palm oil exports. That nuclear option shocked the markets, set off a potential new supply chain crisis and has particular implications on future of crude oil pricing and biofuels in Asia.
A brief recap. Like most of Asia, Indonesia has been grappling with food price inflation as consequence of Covid-19. Like most of Asia, Indonesia has been attempting to control this through a combination of shielding its most vulnerable citizens through continued subsidies while attempting to optimise supply chains. Like most of Asia, Indonesia hasn’t been to control the market at all, because uncoordinated attempts across a wide spectrum of countries to achieve a similar level of individual protectionism is self-defeating.
Cooking oil is a major product of sensitive importance in Indonesia, and one that it is self-sufficient in as a result of its status as the world’s largest palm oil producer. So large is Indonesia in that regard that its excess palm oil production has been directed to increasingly higher biodiesel mandates, with a B40 mandate – diesel containing 40% of palm material – originally schedule for full implementation this year. But as palm oil prices started rising to all-time highs at the beginning of January, cooking oil started becoming scarcer in Indonesia. The government blamed hoarding and – wary of the Ramadan period and domestic unrest – implemented a Domestic Market Obligation on palm oil refineries, directing them to devote 20% of projected exports for domestic use. Increasingly stricter terms for the DMO continued over February and March, only for an abrupt U-turn in mid-March that removed the DMO completely. But as the war in Ukraine drove prices even further, Indonesia shocked the market by announcing an total ban on palm oil exports in late April. Chaotically, the ban was first clarified to be palm olein only (straight refining cooking oil), but then flip-flopped into a total ban of crude palm oil as well. Markets went haywire, prices jumped to historical highs and Indonesia’s trading partners reacted with alarm.
Joko Widodo has said that the ban will be indefinite until domestic cooking oil prices ‘moderate’. With the global situation as it is, ‘moderate’ is unlikely to be achieved until the end of 2022 at least, if ‘moderate’ is taken to be the previous level of palm oil prices – roughly half of current pricing. Logistically, Indonesia cannot hold out on the ban for more than two months. Only a third of Indonesia’s monthly palm oil production is consumed domestically; the rest is exported. An indefinite ban means that not only fill storage tanks up beyond capacity and estates forced to let fruit rot, but Indonesia will be missing out on crucial revenue from its crude palm oil export tax. Which is used to fund its biodiesel subsidies.
And that’s where the implications on oil come in. Indonesia’s ham-fisted attempt at protectionism has dire implications on biofuels policies in Asia. Palm oil prices within Indonesia might sink as long as surplus volumes can’t make it beyond the borders, but international palm oil prices will remain high as consuming countries pivot to producers like Malaysia, Thailand, Papua New Guinea, West Africa and Latin America. That in turn, threatens the biodiesel mandates in Thailand and Malaysia. The Thai government has already expressed concern over palm-led food price inflation and associated pressure on its (subsidised) biodiesel programme, launching efforts to mitigate the worst effects. Malaysia – which has a more direct approach to subsidised fuels – is also feeling the pinch. Thailand’s move to B10 and Malaysia’s move to B20 is now in jeopardy; in fact, Thailand has regressed its national mandate from B7 to B5. And the reason is that the differential between the bio- and the diesel portion of the biodiesel is now so disparate that subsidy regimes break down. It would be far cheaper – for the government, the tax-payers and consumers – to use straight diesel instead of biodiesel, as evidenced by Thailand’s reversal in mandates.
That, in turn, has implications on crude pricing. While OPEC+ is stubbornly sticking to its gentle approach to managing global crude supply, the stunning rebound in Asian demand has already kept the consumption side tight to match that supply. Crude prices above US$100/b are a recipe for demand destruction, and Asian economies have been preparing for this by looking at alternatives; biofuels for example. In the past four years, Indonesia has converted some of its oil refineries into biodiesel plants; in China, stricter crude import quotas are paving the way for China to clamp down on its status of a fuels exporter in favour of self-sustainability. But what happens when crude prices are high, but the prices of alternatives are higher? That is the case for palm oil now, where the gasoil-palm spread is now triple the previous average.
Part of this situation is due to market dynamics. Part of it is due to geopolitical effects. But part of it is also due to Indonesia’s knee-jerk reaction. Supply disruption at the level of a blanket ban is always seismic and kicks off a chain of unintended consequences; see the OPEC oil shocks of the 70s. Indonesia’s palm oil export ban is almost at that level. ‘Indefinite’ is a vague term and offers no consolation to markets looking for direction. Damage will be done, even if the ban lasts a month. But the longer it lasts – Indonesian general elections are due in February 2024 – the more serious the consequences could be. And the more the oil and refining industry in Asia will have to think about their preconceived notions of the future of oil in the region.
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