OPEC Still Very Much Alive As Saudis Learn to Tread Softly
“In the absence of a major financial meltdown, oil will end 2016 north of $60 a barrel,” wrote this columnist in early January. I’m sticking to that view. Having sunk to a 13-year low in mid-February, crude prices have since risen by more than 80pc – and last week broke through $50 for the first time since last November.
This significant oil price rise is happening, though, despite and not because of the once all-powerful Opec exporters’ cartel. But that’s not stopping Opec from trying to reestablish itself as the supply-limiting force it once was.
While there was no agreement on a production cap at the 169th Opec summit in Vienna last week, there was a definite air of rapprochement – led, unusually, by Saudi Arabia. The world’s swing producer, often dubbed the world’s central bank of oil, throughout Opec’s 56-year history the Saudis have been used to getting their way. The Desert Kingdom, perhaps uncharacteristically, is now learning to tread more softly.
Oil-importing Western nations – including the US, much of the EU and, in recent years, the UK as well – ordinarily view falling oil prices as an unequivocally good thing. Cheaper fuel represents a net transfer of wealth from oil exporters to importers. While that’s still partially true, financial markets everywhere have been decidedly uneasy over the last two years, as oil prices have languished during a two-year supply glut.
One reason is that traders have anyway been spooked by other considerations – whether fears over the Chinese slowdown or more fundamental concerns posed by central banks’ endless reliance on monetary expansion and the pursuit of negative interest rates. Plunging oil prices added to the cocktail of risks, though, by threatening to spark a financial collapse.
Given the extent to which upstart US “shale” producers have taken on debt in recent years, as America has strove for “energy independence”, crude around $30 a barrel was threatening their ability to pay creditors – including many big Wall Street banks. That drove distressed debt levels not seen since the peak of the 2008 crisis, with hundreds of billions of dollars’ worth of US energy bonds viewed as “the new sub-prime”, posing broader systemic dangers.
The recent rise in crude is welcome, then, in that it has reined-in the yield spread of American “energy junk bonds” above Treasury bills from over 20 to less than 10 percentage points. For now, global financial markets have dodged a bullet, thanks to rising crude. The danger now is that oil increases too quickly and kills of what remains off what remains a very fragile Western recovery. So, ideally, while oil around $50 is OK, and I think we will see $60, we don’t want it rising too much above that. Once oil approaches $70, the downsides of expensive crude for us oil-importing nations – slower growth, and maybe even inflation – begin to kick-in once again. That’s one reason Opec, now seen by many as a spent force, should definitely not be dismissed.
The sharp fall in oil prices was, of course, brought about by Saudi. Back in mid-2014, Riyadh stunned the world by announcing a production hike into the face of falling prices – driving down prices even more. The idea, of course, was to knock high-cost North American shale producers decisively out of the market, so protecting Opec’s market share. As Saudi, Kuwait and other large Opec members flooded world markets, crude nose-dived, losing 70pc over 18 months.
The Saudi’s glut strategy worked so well, it back-fired. While many shale outfits in the US and Canada were clearly hit, the extent of the drop meant even low-cost Opec members suffered. Ultra-cheap oil cost the big Arab exporters $350bn last year, says the International Monetary Fund, with such nations relying on crude for around four-fifths of government revenue, rising to nine-tenths in Saudi itself. Nursing depleted financial reserves, a 15pc-of-GDP budget deficit and multiple sovereign downgrades, Riyadh has spent much of 2016 under serious fiscal pressure – while trying to engineer a price rebound by securing an Opec-wide production cap to reverse the supply glut.
While such a cap remains elusive, prices have risen anyway. That’s because the solution to low oil prices is, in part low oil prices – which cut supply by making production uneconomic for higher-costs producers, while also lowering investment in new fields. So far this year, we’ve seen the biggest fall in non-Opec oil output in a quarter of a century. And while US shale producers have shown resilience, and become more efficient, America’s daily crude output remains below 9m barrels and has just slipped to its lowest weekly level since September 2014.
More broadly, the global surplus of crude production over consumption, estimated at 1.5m barrels daily during the first quarter of 2016, will be just 200,000 during the second half of this year, according to the International Energy Agency, the Western world’s energy think-tank. On the demand side, despite slowing global growth, the IEA remains confident world oil consumption will keep rising this year, by 1.2m barrels a day or 1.3pc, with a booming India almost out-pacing a slowing China as “the main engine of global demand growth”.
While US crude inventories remain high, news emerged last week they’ve fallen in recent weeks, as supply has weakened and demand has ticked up. Recent production outages in Canada, Nigeria, Libya and elsewhere have also taken barrels off the market. Such problems can easily be reversed, though, and at $50 a barrel US shale producers will soon start cranking up, not least as reduced credit risk will help such outfits re-capitalize. All this, plus Opec’s inability to agree a production cap, confirmed in Vienna on Thursday, has led some to conclude crude will soon head back down. I’m not so sure – not least as something new is happening within Opec.
As well as Saudi, the cartel contains another really big beast, of course – Iran. Boasting the world’s fourth-largest oil reserves and biggest haul of natural gas, Iran has the makings of an energy colossus. Since January, when oil-export sanctions were lifted following a deal on its nuclear program, Iran has boosted its daily production by 400,000 barrels a day, to 3.3m. While significant, this remains well below the 5m barrel 1970s hey-day under the Shah.
Years of sanctions, and ancient enmity towards Sunni-dominated Saudi, meant Shia-led Iran has been determined to increase output as fast as possible in recent months, undermining any Opec production cap. That remained the case last week.
Yet the tone of relations between the two was markedly warmer than during April’s ill-fated Opec meeting in Doha. “The market is balancing – trends are good,” said new Saudi energy minister Khalid al-Falih, even though Tehran wouldn’t agree a production cap. “I’m generally happy,” said his Iranian counterpart Bijan Zanganeh, even though Saudi’s production cap proposal remains on the table.
Clever-clever assumptions by Western analysts that the Saudis and Iranians hate and distrust each other so much they’ll never work together in Opec, guaranteeing the cartel’s future impotence, are not only naïve but disproved by history. While determined to reach 4m barrels, Tehran is in no mood to do the West any favours by keeping oil markets flooded and prices low – not while, despite the formal end of sanctions and can-do rhetoric from Washington, the US continues to exclude Iranian banks from the vital Swift international payment network.
“Don’t think that Opec is dead,” said Abdalla Salem el-Badri, the out-going Secretary General. “Opec is alive”. I happen to think he’s right.