Traditionally, Iraq has been exempt from any quotas imposed on the member nations of OPEC over the past decade and a half. It is recognition of the post-war realities of Iraq, still highly dependent on its energy industry to support the country’s diversification plans. So it was a surprise that Iraq joined the rest in OPEC in agreeing to a supply freeze in November and that Iraq itself had agreed to slashing its production by 210 kb/d.
Perhaps it is a sense of shared responsibilities – even though rumblings from port loading data in January and February 2017 seem to indicate that Iraq actually increased exports – the government is maintaining rhetoric that it is sticking to implementing the cuts. It is true that Iraq has a tougher time than other OPEC members in the quotas: its economy is less diversified than say, Iran or Kuwait, and its oil industry has the highest proportion of foreign party involvement in the Middle East. And the latter have included provisions in their contracts that they will be compensated in the event that Baghdad capped output for reasons beyond the drillers’ control.
However, the toughest part of the equation for Iraq lies in its north. While Saudi Arabia has full control over its wells; the Iraqi spigot has a leak. It’s a leak that sends almost 600 kb/d of crude oil internationally overseas through Turkey. It is the Kurdistan Regional Government.
The divide between the Arabic south and the Kurdish north has been
present since before the reign of Saddam Hussein. However, since the
post-Saddam era, the Kurds in Iraq have been asserting their independence,
going as far as demanding a referendum for the creation of a separate state.
More importantly, they are a bastion against Islamic State militants, seizing
territory in the north of Iraq since 2014 and the oil fields associated with
it. This gives the Kurds oil revenue of their own, even if Baghdad does not
recognise Kurdish control over the Bai Hassan and Avana fields, claiming they
belong to the Oil Ministry’s North Oil Co instead.
This means that Baghdad has no control over what the Kurds produce
and how much they export. The Kurds oppose the quotas – their state economy is
even more dependent on oil than Iraq as a whole – and Baghdad has no mechanism
to impose cuts on the north. Under the national budget, the Kurdish north is
allocated estimated production targets of 250 kb/d; data from September to
November show the Kurds have been increasing output towards 600 kb/d, exporting
it to the Turkish oil hub of Ceyhan, where it gets sent to the wider world.
This therefore places the burden of adhering to cuts beyond the 210 kb/d agreed
on the south, where production contracts and an ailing economy complicate
matters. The Iraqi Kurds are also an effective shield against ISIS, as the
Iraqi government prepares to retake the city of Mosul from the militants.
In principle, Iraq’s agreement to the OPEC quotas is a big step
forward in its admission of responsibility to the organisation. In reality,
Iraq is really two separate countries operating two separate oil economies with
separate objectives. Iraq will most certainly be a member of OPEC that will
flout the supply cuts; and it also won’t be the last. The supply freeze, as it
always has, will now fall on the shoulders of Saudi Arabia, Kuwait and the UAE.
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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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