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Are higher global oil prices likely?

Thursday, May 10, 2018

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The world economy consumes approximately 97 million barrels per day (mbpd) of various types of crude oil. The Organization of the Petroleum Exporting Countries (OPEC), with 14 member countries, collectively produces on average 31 mbpd, with Saudi Arabia the de facto leader producing the largest amount of about 10 to 11 mbpd.

Since the formation of OPEC in the 1970s Saudi Arabia has been the “swing supplier” managing that supply of oil in the global marketplace — and by extension the price of which the commodity is traded. Then came the disruptive, uncontrolled supply of the US “Tight Shale Sweet Light” crude oil to the market, which eroded the effectiveness of OPEC classic methods of stabilising the oil market.

Oil price reached a historic high of US$140 per barrel in mid-2008 and dropped to a low of US$41 per barrel in 2009. The price rocketed up to US$113 per barrel in 2011, then fell to US$47 in late 2014, then further below US$30 per barrel in 2016. Never have oil prices seen such volatility in recent years, if at all.

The volatility is primarily caused by the US shale oil producers and OPEC's several failed attempts to shut down the US oil production, which has proven to be resilient against OPEC's best efforts on its own.

The challenge for OPEC countries is that they favour a high oil price to support their economies. Countries, such as Venezuela, Nigeria, Iraq and Libya to name a few, without large sovereign funds reserved require oil prices of between US$80 to US$100 to balance their national budgets. However, higher global oil prices incentivise more US shale oil producers to produce more of their expensive “tight oil” to the market, thus increasing supply and causing prices to collapse. Sustained low oil prices cause financial distress and bankruptcy for shale producers forcing them out of the market or shutting down their production, thus reducing supply and causing oil prices to rise. It is this new disruptive cycle which leads to price volatility that OPEC is struggling to manage.

In the past, before the US shale oil producers, Saudi Arabia, basically on its own, would use its spare capacity to stabilise global oil prices. If the supply of oil in market was tight, they would intervene and produce more to balance the market. The converse is true, if the global inventory level of oil was too high, causing oil prices to fall, they would reduce their production of oil causing prices to rise.

Thus, Saudi Arabia was considered the swing supplier and the country that the world would look towards to in stabilising global oil price. But, then came the technologically innovative US shale oil producers; when OPEC reduced their output the Americans produced more of their oil and increasingly took market shares away from OPEC.

At their annual general meeting, at their headquarters in Geneva, Switzerland, in November 2015, OPEC made an unconventional decision not to curtail their production output amidst high inventory levels and growing levels of crude production for their US shale oil producer counterpart. The net effect was oil price tanked to below US$30 per barrel in 2016.

OPEC, and particularly Saudi Arabia, recognising that they could not balance the market alone without losing market share to non-OPEC producers such as the US, Russia, Kazakhstan, to name a few, decided in December 2016 to form an alliance with 11 non-OPEC oil-producing nations, led by Russia, to jointly cut oil production by removing 1.8 mbpd from the market, which represents approximately two per cent of global production. The agreement required OPEC to decrease output by appropriately 1.2 mb/d and non-OPEC producers by approximately 600,000 b/d — of which Russia would account for 300 mbpd. The agreement was set for January 2017 and was scheduled to end in March 2018; however, on May 25, 2017 they agreed to extend the cut until December 2018. The agreement was over-sighted by OPEC's president, Saudi Arabia's Energy Minister Khalid al-Falih and OPEC Secretary General Mohammed Barkindo.

As of March 13, 2018 Russian Energy Minister Alexander Novak tweeted that due to higher oil prices Russia's federal budget has received US$29.41 billion more and Russias oil companies' revenues increased collectively by US$12.11 billion since the start of 2017. The improved cash flow resulted from oil price increases between US$15 - US$20 when compared to the price before the OPEC and non-OPEC nations agreement.

OPEC also faces this dilemma: If their actions cause the oil prices to increase too much it will incentivise increased production for the US shale producers, which will be offsetting the reduction that they seek. The US Energy Information Agency (EIA) has reported that the total US crude oil production averaged 9.3 million b/d in 2017, ending the year with production of 9.9 million b/d in December. EIA projects that US crude oil production will average 10.7 million b/d in 2018, which would mark the highest annual average of US crude oil production level, surpassing the previous record of 9.6 million b/d set in 1970. EIA forecasts that 2019 crude oil production will average 11.3 million b/d in the US, the world's top oil consumer, which now rivals Saudi Arabia and Russia as the world's biggest producer. This is a significant achievement for the US, whose crude oil production was approximately 4.9 mbpd between 2008 and 2009.

According to the EIA, the crude oil inventory levels of the 35-members Organisation for Economic Co-operation and Development (OECD) countries has declined by 183.4 million barrels, or six per cent, between January 2017 and January 2018. The significance of the OECD countries is that they account for 78 per cent world gross domestic product, over half of the world's energy consumption, and 18 per cent of the world's population. OPEC's deal with the other selected non-OPEC countries have been yielding some degree of success by reducing global oil inventory levels, reducing oil price volatility and most importantly increasing the price from below US$30 in 2016 to between US$60 - US$70 as of March 2018, albeit rising level of US oil production. The compliance rate amongst the agreeing parties is over 100 per cent and the deal is expected to remain in force until December 2018 with Saudi Arabia's Energy Minister Khalid al-Falih's intention for an extension to 2019.

Saudi Arabia and Russia power play

Reuters News, on March 27, 2018, released an exclusive news article that may be the best indicator of higher sustained global oil price for the medium term at minimum. Reuters reported that Saudi Arabia's Crown Prince Mohammed bin Salman and Russian President Vladimir Putin are considering an unprecedented long-term agreement to exert greater control over global crude oil supplies and influence the price of crude oil globally. OPEC has demonstrated a production capacity of 33 mbpd, and Russia 11 mbpd, which collectively represents over 45 per cent of global supply.

Interestingly, OPEC and Russia want to increase oil prices and lessen the influence of US shale producer. Riyadh and Moscow are considering a 10-20-year agreement, which will make Russia a co-operating de facto member of OPEC. Both countries will now be the swing supplier of global crude oil, thus enhancing a coordinated approach in balancing the oil market. This agreement, if fully realised (the details are yet to be seen), would see oil price trading at higher prices with less volatility.

There are several reasons Saudi Arabia and Russia want to see the back of persistent low oil prices. Firstly, in an attempt to diversify their economy away from oil and gas, Saudi Arabia has plans to raise funds through the floatation of a five per cent stake in State Saudi oil company Aramco in an initial public offering (IPO) that was schedule for earlier this year. The plan has, however, been delayed primarily because of low oil price. Bin Salman has indicated that the IPO is still on for late 2018 or early 2019, according to a news report from Reuters. It is very likely that Saudi Arabia is working diligently to raise oil prices above US$80 per barrel. A higher oil price will provide a basis for a higher IPO price for Saudi Aramco, thus generating potentially more income without issuing more than the five per cent stake of their national treasure.

Secondly, Saudi Arabia is currently fighting a war with their neighbouring country, Yemen, and support its proxy war against President Bashar al-Assad of Syria, incidentally, who Russia strongly supports. In December 2017, oilprice.com reported that: “The Saudi economic contraction comes as the world's top oil exporter tries to cope with persistent budget deficits that began in 2014 when oil prices plummeted. In the past four years, Riyadh posted a total of $258 billion of budget deficits, withdrew $240 billion from its reserves and borrowed around $100 billion from domestic and international markets.” The International Monetary Fund (IMF) 2017 report indicated that Saudi Arabia's economy will stall with growth “close to zero” due to lower oil revenue. The IMF lowered its 2017 growth forecast to 0.1 per cent from 0.4 per cent, citing OPEC's production cuts and uncertainty over oil prices. The fund said last year that Saudi Arabia needed oil prices to be at US$70 a barrel in 2018 to balance their budget.

Russia is particularly upset with the US-led international sanctions against its country — imposed in response to Moscow's annexation of Crimea and involvement in the armed conflict in south-east Ukraine in 2014. The subsequent economic outfall on Russia's economy has caused massive capital flight and devaluation of the Russian ruble. According to a report published by the IMF, Russia saw near-zero growth in GDP in 2014 and was moving into a recession.

In addition, several key OPEC countries, particularly but not limited to, Venezuela, Nigeria, Libya, Iran and Iraq, have all indicated the need for high oil prices to support their economy.

The battle lines

In concluding, the battle lines are now clearly established. OPEC and Russia want greater control over oil supplied to the market. The swing suppliers increased crude oil prices to protect and increase their collective share of the global oil market for the next 10 to 20 years. On the other hand, the US is aggressively seeking to reduce its dependency on imported oil and to increase it global market share, since Congress, in late 2015, lifted a 40-year ban on US oil producers exporting crude oil.

To achieve its objective, the US oil producers need a willing swing supplier to maintain stable higher oil prices so that they can continue extracting more of their expensive oil, or “tight oil” as it is referred to by the Saudis. OPEC and Russia are however no longer willing to sacrifice market share to the US shale producers. The question for oil-importing countries, such as Jamaica, is: Will higher oil prices be a norm for the future or price volatility?

Stanford Graham is a senior lecturer at the University of Technology, Jamaica. Send comments to the Observer or energy.research.info@gmail.com.

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