Friday, July 06, 2018 /09:20 AM /FDC
Two weeks after one of the most eagerly anticipated Organization of Petroleum Exporting Countries (OPEC) meetings in recent time, United States President Donald Trump tweeted – “The OPEC Monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $’s. This must be a two way street. REDUCE PRICING NOW!”
Simple economics tell us that when demand is fixed or growing, and supply is curtailed, or when there is the expectation of a decline in supply, prices will rise. What President Trump fails to realise is that his decision to scrap the Iranian nuclear deal and then put international firms under pressure to cut off Iranian oil imports by early November, has become perhaps the biggest force at play in the oil price equation. A few countries will be granted more time to adjust than others, but a complete blockade is expected. This is already driving oil prices back up towards $80pb and may end up hurting the US economy.
After a week of edgy negotiations at its headquarters in Vienna, OPEC agreed on a deal to raise oil production by one million barrels per day (mbpd) – without saying how it would allocate the increase amongst its 14 member countries. The deal effectively signals a return to compliance, as the cartel – and its allies – have been exceeding supply cuts agreed to in November 2016. Markets were hardly surprised by the outcome of the meeting, though the modest increase of 1mbpd, beginning next month, jolted markets enough to push the price of Brent up sharply by 2.19% to $74.65pb. The meeting also consolidated the present OPEC power dynamic, in addition to which parties are the chief beneficiaries of the deal and who, going forward, has the most to lose.
The run-up to the meeting was one of the most contentious in recent years. With global crude oil stockpiles nearing the five-year average oil storage levels of the Organisation for Economic Co-operation and Development (OECD) countries, the oil market is in a place it has not been in over four years. Any threats to output have a bigger effect on prices.
Internal fractures within the cartel doused expectations of a consensus to raise production. Russia and Saudi Arabia— the largest OPEC and non-OPEC crude producers — were both pushing for supply controls to be relaxed. Russia proposed an increase of 1.5mbpd to effectively wipe out the existing supply cuts of 1.8mbpd. The Saudis were a bit more conservative with their proposal for a 500,000-600,000bpd hike. Both countries believe that oil prices would hit $100pb with-out OPEC’s action and this would only incentivize US shale production and end up dragging down oil prices. OPEC members such as Iran, Iraq and Venezuela were firmly opposed to any relaxation of supply cuts, fearing a slump in prices. At the back of their minds, OPEC also had the potential impact of an anticipated fall in Iranian oil exports as sanctions by the US begin to take effect.
OPEC's alliance with Russia and nine other producers to curb oil output by 1.2mbpd in November 2016 has helped to clear a global supply overhang that weighed on prices for years and propped up oil prices. What has been most impactful is the strict adherence of OPEC members to the agreement which signals to the market that the cartel is willing to do everything possible to restore balance. OPEC is once again being viewed as a force to reckon with. Compliance levels exceeded the standard 100% level, reaching 162% in May as a result of output disruptions in Libya, Venezuela, Iran, and Nigeria. In addition, 7 out of 12-member states had output cuts in excess of the levels set by OPEC, further boosting the compliance rate to over 1.9mbpd.
The deal, as it stands, speaks of an increase in production but is silent on specific country quotas among the 14 members. Given the inability of some members to sufficiently ramp up crude production and produce at even their previous quotas, it leaves just a handful of members like Saudi Arabia, the United Arab Emirates and Kuwait that have the ability to increase output with the task of doing so. Saudi Arabia, OPEC’s de-facto leader and once the world’s swing producer, is likely to account for the lion’s share of the production increase and claims to have 2mbpd of spare production capacity. However, it can only realistically add about 1mbpd without additional drilling. It will allow the country capture more market share at the expense of Venezuela and Iran, in the run up to the Initial Public Offering of the state oil company – Saudi ARAMCO.
The US & Donald Trump
What most would call political interference by the US, President Trump would probably refer to as 21st century diplomacy at its most tacit and efficient form. In a barrage of tweets over the last few months, Trump had been unrelenting in his accusations of OPEC being responsible for the return of oil prices, and in turn US gasoline prices, to multi-year highs through its policy of limiting out-put. Just as Trump wished, Saudi Arabia, in what appeared to be a switch in approach to oil pro-duction, lobbied hard for OPEC to increase production.
If the ban on Iranian oil imports is complied with, given current output disruptions in Nigeria and Libya, and US sanctions on Venezuela that have lowered oil exports, global spare capacity is likely shrink to nothing by the end of 2018. This is also coming at summer time when there is typically increased consumption – in the US and the Middle East. The US mid-term elections are a mere four months away, average gas prices – at $2.82 per gallon are gradually approaching the $3 per gallon threshold. This is 16.5% higher than the 2017 average of about $2.42 per gallon. Trump will need oil prices to fall to about $65pb for gasoline prices to return to their 2017 average.
Iran & Venezuela
Both economies are facing sanctions from the US that affect their oil exports; both are facing losses in market share; both were initially resolute in their demand that OPEC not raise production and both have little to gain from a drop in oil prices.
Venezuela is currently in the middle of a drawn out economic crisis that has led to oil output falling by 500,000bpd below its OPEC quota. It has no spare capacity and has been very vocal in its objection to countries with additional capacity, like Saudi Arabia, filling its output gap. It believes its out-put would recover in another three-four months, therefore it is unnecessary for another producer to step up in its stead. Iran’s output is expected to fall by at least a third by the end of 2018 as a result of US sanctions. A loss in market share, amid a deal to balance the oil market in a bid to keep prices from rising too much, is a raw deal for both countries at this time.
Oil markets are becoming increasingly politicized, and with Trump keen on lower prices, markets should brace themselves for increased volatility. OPEC’s renewed relevance is hinged somewhat on the co-operation of Russia and nine other non-OPEC producers. This presents a need to make the alliance more formal and permanent – at least with Russia. The move would bring the two largest exporters of crude oil – Saudi Arabia and Russia, accounting for 21mbpd – together under an alliance different from OPEC. If this were to become reality, they would wield much more influence on global oil prices and would become a rival to OPEC over time.