Last week, the US launched 59 Tomahawk missiles against the Syrian government in response to chemical gas attacks on its own the civilian population there. Then later in the week, the US announced that it has dropped the GBU-43/B Massive Ordinance Air Blast (MOAB) bomb – better known as the Mother of All Bombs – for the first time in Afghanistan, targeting an underground network of ISIS insurgents. More worryingly, the Trump administration has opened the possibility it may launch a first strike against North Korea. US warships are already gathering around South Korea, joined by some Japanese battleships as well, while on the other sides, reports have come in that China is amassing as many as 150,000 troops along its North Korean border.
Crude oil promptly rose on the news about the Syrian missile attack. Considering that from the last 3 years of on-going conflict in Libya, northern Iraq and Yemen in which the market completely ignored any substantial risk to oil supply, the events last week seems to be taking a different perspective. The market appears to be considering real geopolitical risk arising from the new conflicts at play now. Regardless if nothing comes out of it in the ends.
Concerns are growing about the possible reversal of the Iranian nuclear agreement, which may result in a cut of Iranian supply. Where there was optimism of US – Russian relations is now looking the other way. The prospect that Donald Trump will remove trade sanctions on Russia is now looking more remote than ever. But more worrying is the situation in North Korea. A first strike on the part of the US could trigger a disproportionate retaliation by the belligerent nation, with South Korea caught in the crossfire. An important hub for oil and gas refining and trade in the region, most of South Korea’ important oil and gas facilities are in the safer southernmost part of the peninsula, but capital Seoul is less than 60km from the North Korea border. If North Korea has a nuclear-capable weapon, as is widely suspected, carnage could be unleashed, engulfing not just the Korean Peninsula, but Japan and China as well.
The issue of geopolitical risk can also be linked to the unpredictable nature of the current White House and Mar-a-Lago (depending on the day of the week). It has been a week of unprecedented flip and flops in relation to several core election promises. Trump’s more extreme campaign promises abated this week, to the chagrin of some of his more right-wing supporters. He failed to label China as a ‘currency manipulator’ during his meeting with Chinese premier Xi Jinping, which would have likely started a disruptive tit-for-tat trade war. He walked back on his claims that NATO, saying the organisation was no longer ‘obsolete’. Oil traders are wary that Trump may not have consistent policy viewpoint on how far he will go with the growing conflicts. His promise to not divulge military plans as a measure to keep his enemies guessing, may just keep the markets guessing as well, creating uncertainly.
The issue about geopolitical risks, also comes at a time when the market appears to be tightening up. OPEC is predicted to proceed with the cuts in May, allowing for further excess stock depletion. This could put the market into recovery mode in the next half of the year. Any unexpected or perceived shocks to supply from wars or sanctions may drive prices up further.
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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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