Easwaran Kanason

Co - founder of NrgEdge
Last Updated: December 17, 2021
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Business Trends

The Greek alphabet has taken particular prominence in 2021. Not because use of the language is spreading but because of its connection with the Covid-19 pandemic; instead of naming new variants of concern after the country the mutation was first detected in, the World Health Organisation began naming variants according to letters of the Greek alphabet. There was alpha, beta, gamma and delta – the quartet that plunged most of the world into lockdown earlier this year. Successful vaccination campaigns worldwide managed to contain the spread of those variants, to a point where some semblance of normality began to emerge. And then, the WHO announced that there was a new variant of concern emerging from southern Africa, naming it after the 15th letter of the Greek alphabet: Omicron.

When the first cases of Omicron were reported to the WHO from South Africa on 24 November, news began spreading that the new variant had an ‘unusually large number of mutations’ with concerns that Omicron might have higher transmissibility, greater effect on the body and a higher level of vaccine resistance. By the end of November, the concern over Omicron had turned into a full-blown panic, as countries globally reverted to travel restrictions and the variant detected in over 50 countries already. Fears of a return to lockdowns as health systems come under threat suddenly re-emerged to become very, very real.

The reaction on the oil markets was swift. Overnight, Brent and WTI benchmarks lost over US$10/b, falling from the US$80/b level to below US$70/b – one of the largest single-day drops on record. Even with car and air travel fuel demand was slowly recovering, the refining industry was also enjoying higher margins, given that the first wave of Covid-19 wiped out several vulnerable refineries already. Some of these sites – especially in Europe and North America – have been revived as green/renewable fuel sites, but that removal of capacity meant that the refineries that were left had been able to take advantage from the rapid desire to return to normal life and normal travel patterns. Supply crunches from natural gas putting pressure on power generation also provided some lift in terms of demand. Omicron threatens to upend that.

Adding more wrinkles to the equation, Omicron’s emergence came at a critical time; as the world’s largest crude oil producers and the world’s largest crude oil consumers were facing off over the high level of oil prices. Despite internal strife and differences on momentum, OPEC+ has managed to stick to its roadmap to ease its supply quotas with a monthly addition of 400,000 b/d from the massive 10 mmb/d cut that was agreed back in April 2020. Calls from major consuming nations for OPEC+ to increase the speed of easing fell on deaf ears, as the group stuck to its guns and emphasised the need for caution. That, however, lead to oil prices hitting their highest level in years and triggering inflationary concerns against a bruised and barely recovering global economy. But led by Saudi Arabia, OPEC+ argued that a steady and cautious approach was better against a shifting market, pointing out that its own technical analysis suggested that its agreed pace would largely eliminate the supply glut by early 2022. With the emergence of Omicron, that approach now looks correct. The drama of Covid-19 is such that new variants and mutations could be detected at any time, each one potentially plunging the oil markets and the world back into chaos.

OPEC+’s cautious approach, however, was opposed by major consuming nations, publicly complaining of its inflationary effects. In the lead-up to COP26 in Glasgow, the world’s largest economies were in the ironic position of committing to a long-term transition to renewables to reduce climate change emissions, while simultaneously demanding that OPEC+ pump more crude in the short-term to ease prices. When that approach didn’t work, coordination began. In effect, an ‘anti-OPEC+’ was born, which can be traced back to the historic US-China summit in mid-November where the two opposing nations agreed to cooperate on items on which they have common ground. The result of this was an agreement by the USA, China, Japan, South Korea, India and the UK to draw on crude from their strategic stockpiles as a counter-measure against OPEC+’s reluctance, to create ‘artificial looseness’ in oil markets. Such a partnership is unconventional and unprecedented, almost a measure of last resort. But it does bring together countries facing the same problem, with the usually-secretive China having already admitted to tapping into its reserves at least twice this year. Collectively, the countries would release volumes of crude oil from their strategic petroleum reserves on an undisclosed schedule to tame high fuel prices, with the USA committing to release 50 million barrels on its own. That release remains on track even as Omicron hit and crude prices abated, but the longer-term approach of anti-OPEC+ is in question. But even if that pans out, the fate of the demand-side alliance is always going to be finite. There is only so much that strategic releases can do. At some point, the reserves will run out and, crucially, will have to be replenished from the market, potentially at a higher cost, which would defeat the purpose of the move itself.

Since the initial Omicron hit, crude prices have recovered somewhat, rising above the US$70/b, but not very much further. The exact severity of Omicron is yet unknown, even though evidence suggests that is more transmissible. With vaccination drives continuing and booster shots expanding, the actual impact of Omicron might not be as serious as imagined. That’s still a big ‘might’, but after the initial knee-jerk reaction, countries will still have to have a roadmap out of the pandemic that will include having plans to live with Omicron and future variants. Covid-19 is now endemic and a Covid-zero strategy – bizarrely still practiced by China and Hong Kong – is illogical. Fluctuations in supply from OPEC+ and anti-OPEC+’s opposing positions might shift fundamentals by a few percentage points in either direction, but are merely temporary diversions from the direction of the new normal.

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Saudi Aramco Moves Into Russia’s Backyard

International expansions for Saudi Aramco – the largest oil company in the world – are not uncommon. But up to this point, those expansions have followed a certain logic: to create entrenched demand for Saudi crude in the world’s largest consuming markets. But Saudi champion’s latest expansion move defies, or perhaps, changes that logic, as Aramco returns to Europe. And not just any part of Europe, but Eastern Europe – an area of the world dominated by Russia – as Saudi Aramco acquires downstream assets from Poland’s PKN Orlen and signs quite a significant crude supply deal. How is this important? Let us examine.

First, the deal itself and its history. As part of the current Polish government’s plan to strengthen its national ‘crown jewels’ in line with its more nationalistic stance, state energy firm PKN Orlen announced plans to purchase its fellow Polish rival (and also state-owned) Grupa Lotos. The outright purchase fell afoul of EU anti-competition rules, which meant that PKN Orlen had to divest some Lotos assets in order to win approval of the deal. Some of the Lotos assets – including 417 fuel stations – are being sold to Hungary’s MOL, which will also sign a long-term fuel supply agreement with PKN Orlen for the newly-acquired sites, while PKN Orlen will gain fuel retail assets in Hungary and Slovakia as part of the deal. But, more interestingly, PKN Orlen has chosen to sell a 30% stake in the Lotos Gdansk refinery in Poland (with a crude processing capacity of 210,000 bd) to Saudi Aramco, alongside a stake in a fuel logistic subsidiary and jet fuel joint venture supply arrangement between Lotos and BP. In return, PKN Orlen will also sign a long-term contract to purchase between 200,000-337,000 b/d of crude from Aramco, which is an addition to the current contract for 100,000 b/d of Saudi crude that already exists. At a maximum, that figure will cover more than half of Poland’s crude oil requirements, but PKN Orlen has also said that it plans to direct some of that new supply to several of its other refineries elsewhere in Lithuania and the Czech Republic.

For Saudi Aramco, this is very interesting. While Aramco has always been a presence in Europe as a major crude supplier, its expansion plans over the past decade have been focused elsewhere. In the US, where it acquired full ownership of the Motiva joint venture from Shell in 2017. In doing so, it acquired control of Port Arthur, the largest refinery in North America, and has been on a petrochemicals-focused expansion since. In Asia, where Aramco has been busy creating significant nodes for its crude – in China, in India and in Malaysia (to serve the Southeast Asia and facilitate trade). And at home, where the focus has on expanding refining and petrochemical capacity, and strengthen its natural gas position. So this expansion in Europe – a mature market with a low ceiling for growth, even in Eastern Europe, is interesting. Why Poland, and not East or southern Africa? The answer seems fairly obvious: Russia.

The current era of relatively peaceful cooperation between Saudi Arabia and Russia in the oil sphere is recent. Very recent. It was not too long ago that Saudi Arabia and Russia were locked in a crude price war, which had devastating consequences, and ultimately led to the détente through OPEC+ that presaged an unprecedented supply control deal. That was through necessity, as the world faced the far ranging impact of the Covid-19 pandemic. But remove that lens of cooperation, and Saudi Arabia and Russia are actual rivals. With the current supply easing strategy through OPEC+ gradually coming to an end, this could remove the need for the that club (by say 2H 2022). And with Russia not being part of OPEC itself – where Saudi Arabia is the kingpin – cooperation is no longer necessary once the world returns to normality.

So the Polish deal is canny. In a statement, Aramco stated that ‘the investments will widen (our) presence in the European downstream sector and further expand (our) crude imports into Poland, which aligns with PKN Orlen’s strategy of diversifying its energy supplies’. Which hints at the other geopolitical aspect in play. Europe’s major reliance on Russia for its crude and natural gas has been a minefield – see the recent price chaos in the European natural gas markets – and countries that were formally under the Soviet sphere of influence have been trying to wean themselves off reliance from a politically unpredictable neighbour. Poland’s current disillusion with EU membership (at least from the ruling party) are well-documented, but its entanglement with Russia is existential. The Cold War is not more than 30 years gone.

For Saudi Aramco, the move aligns with its desire to optimise export sales from its Red Sea-facing terminals Yanbu, Jeddah, Shuqaiq and Rabigh, which have closer access to Europe through the Suez Canal. It is for the same reason that Aramco’s trading subsidiary ATC recently signed a deal with German refiner/trader Klesch Group for a 3-year supply of 110,000 b/d crude. It would seem that Saudi Arabia is anticipating an eventual end to the OPEC+ era of cooperative and a return to rivalry. And in a rivalry, that means having to make power moves. The PKN Orlen deal is a power move, since it brings Aramco squarely in Russia’s backyard, directly displacing Russian market share. Not just in Poland, but in other markets as well. And with a geopolitical situation that is fragile – see the recent tensions about Russian military build-up at the Ukrainian borders – that plays into Aramco’s hands. European sales make up only a fraction of the daily flotilla of Saudi crude to enters international markets, but even though European consumption is in structural decline, there are still volumes required.

How will Russia react? Politically, it is on the backfoot, but its entrenched positions in Europe allows it to hold plenty of sway. European reservations about the Putin administration and climate change goals do not detract from commercial reality that Europe needs energy now. The debate of the Nord Stream 2 pipeline is proof of that. Russian crude freed up from being directed to Eastern Europe means a surplus to sell elsewhere. Which means that Russia will be looking at deals with other countries and refiners, possibly in markets with Aramco is dominant. That level of tension won’t be seen for a while – these deals takes months and years to complete – but we can certainly expect that agitation to be reflected in upcoming OPEC+ discussions. The club recently endorsed another expected 400,000 b/d of supply easing for January. Reading the tea leaves – of which the PKN Orlen is one – makes it sound like there will not be much more cooperation beyond April, once the supply deal is anticipated to end.

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Market Outlook:

-       Crude price trading range: Brent – US$86-88/b, WTI – US$84-86/b

-       Crude oil benchmarks globally continue their gain streak for a fifth week, as the market bounces back from the lows seen in early December as the threat of the Omicron virus variant fades and signs point to tightening balances on strong consumption

-       This could set the stage for US$100/b oil by midyear – as predicted by several key analysts – as consumption rebounds ahead of summer travel and OPEC+ remains locked into its gradual consumption easing schedule 


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