Easwaran Kanason

Co - founder of NrgEdge
Last Updated: May 28, 2017
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Business Trends
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In Vienna yesterday, OPEC announced that it would be rolling over the landmark supply freeze that began in January 2017 by another nine months. Joining them will be the key non-OPEC members – principally Russia, but other major Central Asian producers – extending the 1.8 mmb/d cuts (1.2 mmb/d for OPEC and 600 kb/d for non-OPEC) through to March 2018. Ordinarily this would be cause for cheer. But instead, the markets reacted in dismay. Brent and WTI plunged by almost 5%, erasing all gains from the last week.

It is an overreaction, certainly, but also evident that the market was expecting a more drastic cut from OPEC to help bolster prices. The extension of the freeze is good, but had already been telegraphed weeks ago by rumblings out of Russia and Saudi Arabia. So that has already been factored into the price – one of the reasons why crude rose over the past week – and traders were looking for a little bit more good news, deeper cuts. When that did not materialise, the sell-off happened.

What’s going on? It took no rocket scientist to predict back in January that the OPEC freeze effect would be blunted by rising production elsewhere. Despite record compliance within the OPEC block – even Iran and Iraq toed the line – once the supply cuts took place, crude from elsewhere rushed to take its place. We saw crude from Alaska shipped to China for the first time, while Japan and South Korea offset Saudi Arabia’s cuts to their supply with crude from West Africa. Buoyed by price signals, American production from onshore shale deposits surged. Two weeks, the American oil rig count blasted past 700 active rigs, the highest in almost two years and is now marching towards 800. This rise in American production is estimated to have offset at least two-thirds of the lost OPEC output. And at current trends, it is estimated that some additional 900 kb/d of oil from the US will be added to global production.  Nelson Martinez, Venezuela's oil minister said "In terms of the threat, we still don't know how much (U.S. shale) will be producing in the near future” after the recent OPEC talks. The Energy Minister if UAE, Suhail bin Mohammed al-Mazroui commented that he personally did not believe U.S. oil production would rise by 1 million bpd  by next year. Representatives from US Shale who attended the Vienna meeting did not provide any specific guidance or projections either,  keeping plans close to their chest.

So analysts were hoping that OPEC would match that with another cut. But getting OPEC to agree on additional cuts is like herding cats. The original November 2016 was landmark, and the high compliance another rare occurrence. But despite this, global inventories and supplies remain high. Part of this is artificial; in the six weeks between announcement and implementation, OPEC members pumped record volumes of crude, stockpiling them to sell during the freeze period. This is evident when you look at OPEC export statistics; they have fallen, but not nearly by as much as production. Extending the freeze may do the trick, to account for this lag. Saudi Arabia certainly seems to agree, pointing out that US crude supplies may have risen over the early period of the freeze, but had fallen for the past seven weeks, which helped convince some OPEC members of the delayed impact. The second half of the year is also a more strategic time to see the impact of the cuts, when the Middle East nations hoard crude to burn for summer power requirements and American/European drivers go out for summer, driving gasoline demand.

But still, there are issues. Libya and Nigeria were exempt for the original OPEC freeze. Their production has been rising following quelling of insurgent activity, while OPEC welcomed its 14th members, Equatorial Guinea, which replaces Indonesia that left last year. The wording of the OPEC announcement suggest that all three will not be expected to produce within the existing quotas, potentially blunting the impact further. Gone are the days when an OPEC freeze was a standalone solution.

Now is this merely a band-aid, kicking the ball further down the road to March 2018 where OPEC will once again have to ask themselves or do we need more cuts earlier? OPEC meets again in November to reconsider output its policy. Reuters reports that “while most in the group now appear to believe that shale has to be accommodated, there are still those in OPEC who think another fight is around the corner". Nigerian Oil Minister Emmanuel Kachikwu commented that “If we get to a point where we feel frustrated by a deliberate action of shale producers to just sabotage the market, OPEC will sit down again and look at what process it is we need to do”.

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High Oil Prices and Indonesia’s Ban on Oil Palm Exports

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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Market Outlook:

  • Crude price trading range: Brent – US$110-1113/b, WTI – US$105-110/b
  • As the war in Ukraine becomes increasingly entrenched, the pressure on global crude prices as Russian energy exports remain curtailed; OPEC+ is offering little hope to consumers of displaced Russian crude, with no indication that it is ready to drastically increase supply beyond its current gentle approach
  • In the US, the so-called NOPEC bill is moving ahead, paving the way for the US to sue the OPEC+ group under antitrust rules for market manipulation, setting up a tense next few months as international geopolitics and trade relations are re-evaluated

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