Easwaran Kanason

Co - founder of NrgEdge
Last Updated: January 3, 2022
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Business Trends

Two things happened in the second half of December that changed the tone that the world talks about oil prices. First, the International Energy Agency announced that global oil market had return to a surplus and the impact of the Omicron Covid-19 variant may lead to an even bigger oversupply in early 2022 as international travel is impeded and demand recedes. And then, a day later, the February Brent crude contract flipped to trade at a discount to the March Brent contract for the first time since March 2020, a contango situation that signals that the market believes the IEA’s statement and that crude oil fundamentals either are or will shift into oversupply soon. That this bear-ish signal is happening in the prompt spread – a heavily-traded and very liquid part of the oil futures curve – shows that the belief is widespread and imminent.

These twin events – which are rooted in the Omicron Covid-19 variant surge – have upended the perceived wisdom that underpinned efforts to rebalance oil supply and demand since November. At that point, crude oil prices had already exceeded US$80/b. On the supply side, the OPEC+ group was not budging from its ‘slowly, softly’ approach of increasing its collective oil supply by 400,000 b/d a month through to April 2022. The group had, however, left its December meeting ‘in session’, to allow it to respond to any short-term signals that the market required more oil than it was prepared to produce. On the demand side, the rise in oil prices was causing inflationary spikes. The US, for example, recorded a 6.8% inflation rate for 2021, the highest level since 1982. Efforts by President Joe Biden, alongside pleas from the leaders of other major consuming nations did not budge OPEC+. So the likes of the USA, China, India, Japan, South Korea and the UK took matters into their own hands, announcing plans to release supply from strategic petroleum reserves to calm the market down.

And then Omicron hit. First recorded in late November, the surge in Omicron cases really began in mid-December, taking root in regions where the pandemic was thought to be under control. In response, European nations have announced strict new restrictions to contain the new outbreak, while existing restrictions that were planned to be eased in Asia and elsewhere look now to be continue indefinitely. The WHO has gone as far to advise that Christmas events be axed, stating that ‘an event cancelled is better than a life cancelled.’ Crude oil prices fell in response, charting one of the steepest one-day falls recently and now hovering in the low US$70/b level. What the major producers or consumers wanted to do, the virus did for them.

From this lens, it seems that OPEC+’s approach – or specifically, Saudi Arabia’s preferred position for the group – was correct. It is, in fact, in line with the predictions of OPEC+’s own technical committee, which forecasted that the supply glut inherited from 2020 would persist over Q4 2021 but be largely eliminated by Q1 2022. The Omicron surge merely brought that timeline forward. Having left its December meeting ‘in session’, OPEC+ is now under less pressure to bow to demands that supply be increased to calm prices. A quickfire decision on supply now looks unlikely; in fact, it could lead to a decision during its January meeting to pause the supply easing in recognition of the ongoing Omicron crisis. This, in our opinion, is unlikely to happen, given that it will not be supported by some key OPEC+ members such as Russia and the UAE. Which should result in a further easing of prices in the short/mid-term.

The Biden administration has gone ahead with the release from its strategic petroleum reserve, in two tranches of 50 million barrels and 18 million barrels. But – apart from China’s own earlier moves – there has been radio silence from the ‘anti-OPEC+’s other members. In the original plan, India was set to release 5 million barrels, Japan about 4.2 million barrels, South Korea about 3.5 million barrels and the UK about 1.5 million barrels; no figures from China but sources suggested a range of 7-15 million barrels. There has been no indication that these countries have followed through. And why would they? The market dynamics have changed up. Strategic releases are a double-edged sword since they are finite and must also be replenished at a later point, possibly at higher prices. The major Asian buyers would also be reluctant to shake their long-standing relationships with major producers just to appease a US president that is up for election in 2024. Curiously, Saudi Aramco raised its January sales price for its crude to Asia and the US, possibly as a subtle punishment for the anti-OPEC+ move and a reminder that Saudi Arabia is still a kingpin.

And the rest of the market has already been acting on the previous price signals. Although generally remaining disciplined, activity in the US onshore shale basins have increased dramatically. The US EIA projects that Permian Basin production will reach 4.96 mmb/d in December, surpassing pre-pandemic highs, and record production is also expected from other plays such as Eagle Ford and Haynesville. Brazilian crude output is also widely expected to have increased over 2021. All of this will have been in response to the price signals sent by the market. After all, which producer doesn’t want to cash in on US$70-80/b crude, especially when breakeven costs are in the US$30-40/b range.

Inflation is real. But political rhetoric did not manage to solve it, given the complexity of oil geopolitics. But, for now, the Omicron variant has calmed down what was an incendiary issue, even if it will be coming at the cost of further lockdowns and restrictions. There is a lesson buried in there somewhere: that the current global situation remains too fragile and too fraught to make definitive projections and plans. OPEC+’s gradual approach has been under fire by many in the second half of 2021, but most would agree now that it has provided a measure of stability and steadiness in a market buffeted by too many dynamic factors. The cost of that is quantifiable – higher inflation – but the market will find a way to balance that. And it has.

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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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