At one point in mid-February, it looked like the Covid-19 virus outbreak was increasingly under control. In China, new cases were reported at a decelerating pace; although the death toll continued to rise, the spread of new infections had slowed down. Then three new hotspots of infection were detected: in the northern industrial heartland of Italy, in South Korea and in Iran. The cases emanating from these new hotspots started accelerating, spreading to the rest of Europe, North America, Latin America and Africa. The outbreak is far from over.
On this news, financial and commodity markets tumbled. Crude oil prices fell to fresh recent lows, with WTI plunging below US$50/b and Brent barely skirting that psychological level. The OECD reports that global economic growth for 2020 could be halved from previous forecasts to just 1.5%, taking Japan and the Eurozone into recession. This was based on the outbreak peaking in China, and mild outbreaks elsewhere. As recent news proves, that assumption looks unlikely, Covid-19 is now approaching the WHO’s definition of a pandemic.
The impact on demand will be vast. In China, industrial production ground to a halt as lockdowns were ordered. But with the new spread, the impact will be even greater, going beyond reduced jet fuel, road transport and petrochemical consumption to consumer demand destruction. Easter is approaching; in Europe, this is accompanied by a traditional spike in transport and consumer consumption. This is now at risk. Ramadhan is also approaching, also accompanied by increased transport and food consumption. This is now also at risk.
The increasingly rapid spread of the virus outside of China has prompted action from even the most reticent of quarters. After an aborted attempt in mid-February to convene an emergency OPEC+ meeting to discuss extending the current supply deal to June 2020, this may now be back on the cards. Russia, which reportedly did not sanction the extension of the deal, is now hinting that it is on board. Vladimir Putin, in an interview, stated that he recognised that ‘steps need to be taken to support oil prices’.
With the OPEC+ club scheduled to meet this weekend to discuss this very topic, any decision will have to be bolder than what was proposed before. This will either be a deeper cuts from existing levels through the end of Q2 2020, or extending the current supply deal through Q3 or even Q4 of 2020; or even a combination of both measures. But while the market may be assuaged by commitments, adherence is more important. The discussion will come at a time when Russian oil production increased by 3.2% y-o-y in February to 11.3 mmb/d. This figure includes condensate, explicitly excluded from the OPEC+ quotas, but does illustrate the continued problem within OPEC+: how to ensure members of the club stick to their pledges.
Beyond prices, there are also other worries. Iran now seems to be a hotbed of infection, with over 1,500 cases reported and 66 deaths recorded; the Covid-19’s average fatality rate of 2% suggests that reported cases in Iran are underestimated. This has implications for oil production and refining operations. With clusters of workers in close proximity, the potential for an infection outbreak on a rig, in a processing centre or in a refinery is high. Already, Shell’s Pulau Bukom refinery in Singapore, the company’s largest has reported a case, prompting a partial quarantine. If the virus was to break out in Iran’s oil facilities, the effect on output could be large. And not just Iran. The virus has already spread to Kuwait, Bahrain, Qatar and Saudi Arabia, traced back to Iran, increasingly the magnitude of potential impact. Of course, this would have a positive impact on prices, but on the whole, for the oil world to deal with a double whammy of demand destruction and reduced supply is a nightmare scenario.
It hasn’t happened yet. But it could. Hopes are now that the global government response to containing the virus moves into serious mode, this will not come to pass. But the risk is there; and in a flip side of the usual risk scenario for oil prices, crude is now trading at a risk discount rather than a risk premium. And until the Covid-19 outbreak has been confidently declared to be contained worldwide, this risk discount will persist and crude prices will remain depressed.
The Covid-19 Global Outbreak:
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In 2020, renewable energy sources (including wind, hydroelectric, solar, biomass, and geothermal energy) generated a record 834 billion kilowatthours (kWh) of electricity, or about 21% of all the electricity generated in the United States. Only natural gas (1,617 billion kWh) produced more electricity than renewables in the United States in 2020. Renewables surpassed both nuclear (790 billion kWh) and coal (774 billion kWh) for the first time on record. This outcome in 2020 was due mostly to significantly less coal use in U.S. electricity generation and steadily increased use of wind and solar.
In 2020, U.S. electricity generation from coal in all sectors declined 20% from 2019, while renewables, including small-scale solar, increased 9%. Wind, currently the most prevalent source of renewable electricity in the United States, grew 14% in 2020 from 2019. Utility-scale solar generation (from projects greater than 1 megawatt) increased 26%, and small-scale solar, such as grid-connected rooftop solar panels, increased 19%.
Coal-fired electricity generation in the United States peaked at 2,016 billion kWh in 2007 and much of that capacity has been replaced by or converted to natural gas-fired generation since then. Coal was the largest source of electricity in the United States until 2016, and 2020 was the first year that more electricity was generated by renewables and by nuclear power than by coal (according to our data series that dates back to 1949). Nuclear electric power declined 2% from 2019 to 2020 because several nuclear power plants retired and other nuclear plants experienced slightly more maintenance-related outages.
We expect coal-fired electricity generation to increase in the United States during 2021 as natural gas prices continue to rise and as coal becomes more economically competitive. Based on forecasts in our Short-Term Energy Outlook (STEO), we expect coal-fired electricity generation in all sectors in 2021 to increase 18% from 2020 levels before falling 2% in 2022. We expect U.S. renewable generation across all sectors to increase 7% in 2021 and 10% in 2022. As a result, we forecast coal will be the second-most prevalent electricity source in 2021, and renewables will be the second-most prevalent source in 2022. We expect nuclear electric power to decline 2% in 2021 and 3% in 2022 as operators retire several generators.
Source: U.S. Energy Information Administration, Monthly Energy Review and Short-Term Energy Outlook (STEO)
Note: This graph shows electricity net generation in all sectors (electric power, industrial, commercial, and residential) and includes both utility-scale and small-scale (customer-sited, less than 1 megawatt) solar.
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The tizzy that OPEC+ threw the world into in early July has been settled, with a confirmed pathway forward to restore production for the rest of 2021 and an extension of the deal further into 2022. The lone holdout from the early July meetings – the UAE – appears to have been satisfied with the concessions offered, paving the way for the crude oil producer group to begin increasing its crude oil production in monthly increments from August onwards. However, this deal comes at another difficult time; where the market had been fretting about a shortage of oil a month ago due to resurgent demand, a new blast of Covid-19 infections driven by the delta variant threatens to upend the equation once again. And so Brent crude futures settled below US$70/b for the first time since late May even as the argument at OPEC+ appeared to be settled.
How the argument settled? Well, on the surface, Riyadh and Moscow capitulated to Abu Dhabi’s demands that its baseline quota be adjusted in order to extend the deal. But since that demand would result in all other members asking for a similar adjustment, Saudi Arabia and Russia worked in a rise for all, and in the process, awarded themselves the largest increases.
The net result of this won’t be that apparent in the short- and mid-term. The original proposal at the early July meetings, backed by OPEC+’s technical committee was to raise crude production collectively by 400,000 b/d per month from August through December. The resulting 2 mmb/d increase in crude oil, it was predicted, would still lag behind expected gains in consumption, but would be sufficient to keep prices steady around the US$70/b range, especially when factoring in production increases from non-OPEC+ countries. The longer term view was that the supply deal needed to be extended from its initial expiration in April 2022, since global recovery was still ‘fragile’ and the bloc needed to exercise some control over supply to prevent ‘wild market fluctuations’. All members agreed to this, but the UAE had a caveat – that the extension must be accompanied by a review of its ‘unfair’ baseline quota.
The fix to this issue that was engineered by OPEC+’s twin giants Saudi Arabia and Russia was to raise quotas for all members from May 2022 through to the new expiration date for the supply deal in September 2022. So the UAE will see its baseline quota, the number by which its output compliance is calculated, rise by 330,000 b/d to 3.5 mmb/d. That’s a 10% increase, which will assuage Abu Dhabi’s itchiness to put the expensive crude output infrastructure it has invested billions in since 2016 to good use. But while the UAE’s hike was greater than some others, Saudi Arabia and Russia took the opportunity to award themselves (at least in terms of absolute numbers) by raising their own quotas by 500,000 b/d to 11.5 mmb/d each.
On the surface, that seems academic. Saudi Arabia has only pumped that much oil on a handful of occasions, while Russia’s true capacity is pegged at some 10.4 mmb/d. But the additional generous headroom offered by these larger numbers means that Riyadh and Moscow will have more leeway to react to market fluctuations in 2022, which at this point remains murky. Because while there is consensus that more crude oil will be needed in 2022, there is no consensus on what that number should be. The US EIA is predicting that OPEC+ should be pumping an additional 4 million barrels collectively from June 2021 levels in order to meet demand in the first half of 2022. However, OPEC itself is looking at a figure of some 3 mmb/d, forecasting a period of relative weakness that could possibly require a brief tightening of quotas if the new delta-driven Covid surge erupts into another series of crippling lockdowns. The IEA forecast is aligned with OPEC’s, with an even more cautious bent.
But at some point with the supply pathway from August to December set in stone, although OPEC+ has been careful to say that it may continue to make adjustments to this as the market develops, the issues of headline quota numbers fades away, while compliance rises to prominence. Because the success of the OPEC+ deal was not just based on its huge scale, but also the willingness of its 23 members to comply to their quotas. And that compliance, which has been the source of major frustrations in the past, has been surprisingly high throughout the pandemic. Even in May 2021, the average OPEC+ compliance was 85%. Only a handful of countries – Malaysia, Bahrain, Mexico and Equatorial Guinea – were estimated to have exceeded their quotas, and even then not by much. But compliance is easier to achieve in an environment where demand is weak. You can’t pump what you can’t sell after all. But as crude balances rapidly shift from glut to gluttony, the imperative to maintain compliance dissipates.
For now, OPEC+ has managed to placate the market with its ability to corral its members together to set some certainty for the immediate future of crude. Brent crude prices have now been restored above US$70/b, with WTI also climbing. The spat between Saudi Arabia and the UAE may have surprised and shocked market observers, but there is still unity in the club. However, that unity is set to be tested. By the end of 2021, the focus of the OPEC+ supply deal will have shifted from theoretical quotas to actual compliance. Abu Dhabi has managed to lift the tide for all OPEC+ members, offering them more room to manoeuvre in a recovering market, but discipline will not be uniform. And that’s when the fireworks will really begin.
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