Oil prices plunged earlier this week as reports of a rift between Russia and OPEC emerged ahead of the OPEC+ meeting held last week. The report suggested that Saudi Arabia could push to ‘exempt’ Russia from the OPEC+ deal, because of Russia’s deep cuts in production and failure to meet agreed-upon quotas.
Since the outbreak of the Ukraine war, global oil supplies have been gravely distorted. One of the core reasons has been relentless western pressure on Russia’s primary export. Today, Russian crude production is already 1 million barrels per day (bpd) below its OPEC quota.
With EU sanctions coming into place, some analysts believe that Russian production could fall by as much as 3 million bpd through the rest of the year.
As Mr.Barkindo, the OPEC Secretary-General had noted earlier in the month, “What is clear is that Russia’s oil and other liquids exports of more than 7 million bpd cannot be made up from elsewhere”.
For now, it seems the report by a leading American newspaper was merely wishful thinking.
Why wishful thinking?
To no one’s surprise, the consequent shortages of sanctions on Russia have reverberated through the markets, and American-led measures have boomeranged to cause significant hardship at gas stations around the country.
With Biden’s America reeling under sky-high inflation and the hotly contested mid-terms just around the corner, the President has been desperate to reduce prices at the pumps, with 59% of voters polled blaming current policies for their predicament.
With gasoline prices reaching record highs of nearly $5 a gallon, the US has been repeatedly pressuring the Saudi government and the UAE authorities to turn on the taps, so to speak, disregard the assigned quotas and ramp up production.
This has been to no avail, as OPEC+ has stood staunchly behind the deal.
If the Russian-Saudi alliance had weakened as per reports, OPEC+ would likely disintegrate, paving the way for increased production. Theoretically, this would quench the market’s thirst and quell price pressures at the pumps in the US.
With the Democratic party’s immediate political future at stake, the administration has tried to bring down price pressures but to no avail. Proposals have included a federal gas tax holiday, capping record-high exports, easing environmental limits, restarting closed refineries, and pressuring private companies to boost production.
For pragmatic or political reasons, each of these options has proved to be a non-starter. With the clock ticking, infighting has escalated in the Democratic camp with Claudia Sahm, a member of President Obama’s Council of Economic Advisers describing it as there being, “…a kind of defeatism.”
Did Ukraine really creep up on America’s Gasoline Prices?
The Ukraine invasion put a huge spanner in the works of the global economy. Oil prices were the first to be affected.
However, this was not as unforeseen as is often suggested. The energy sector has been a calamity-in-waiting for some time. Lackluster investments, weak exploration and production, and delays in the up-gradation of aging infrastructure have been flagged for the better part of a decade. To add this to pressure, since the covid outbreak, there have been mass layoffs and the closure of key refineries, aggravating a structural deficit.
With prices rising and insufficient supply, in desperation, the US had released huge volumes from the strategic reserves, but the effect on prices has proved temporary.
Unsurprisingly, the dissolution of OPEC+ would be a captivating outcome State-side, with Amrita Sen, Founding Partner and Chief Oil Analyst at Energy Aspects, saying that “this is what the US administration would like to happen.”
Au contraire, the US has not helped its case by pushing for the enactment of the controversial No Oil Producing and Exporting Cartels (NOPEC) bill, which is designed to give the United States the ability to file lawsuits against OPEC members for keeping production intentionally low.
Expectedly, there was a backlash by OPEC’s top brass, arguing that this unprecedented measure could hamper the pre-existing supply chains.
The Saudi government has close historical links with Russia and overlapping interests, especially in Turkey. Under the added pressure of the US, the No.1 and No.2 producers of crude oil in the world, continued to collaborate. Indeed, earlier this week, foreign ministers Lavrov and Faisal bin Farhan Al Saud “praised the level of cooperation in the OPEC+ format” and the “stabilizing effect” on the market.
Yet, on reports of the crumbling of the global oil architecture, prices dropped by a steep $7 – $8 in a single day but quickly recovered.
OPEC+ treading the middle path
During yesterday’s proceedings, Saudi Arabia’s role was pivotal in securing higher production quotas, rising from 432,000 additional bpd per month to nearly 650,000 bpd through July and August. The significant increase has placated the US side while Russia’s continued inclusion has kept OPEC+ intact.
The OPEC members have indicated that the change in stance was largely in response to the winding down of Chinese lockdowns in major centers such as Shanghai.
However, the reality is that despite the higher quotas, Saudi Arabia and the UAE are the only two countries with any kind of spare capacity. According to Amrita Sen, volumes will be “very very minimal…we are expecting over the two months only about 560,000 to come to the market…and doesn’t really solve the deficit”.
Optics-wise, this is still a good outcome for Biden in the lead-up to the November elections. In a bid to facilitate a further meeting of the minds, the President will be visiting Saudi Arabia for the first time since taking office in the coming weeks.
Will the Increase in Quotas Help the USA?
The irony is that any positive impact on production will have a very limited effect on what consumers are facing. Although the raw crude market is tight, the downstream refined market is much tighter, and that is where the problem arises for everyday Americans.
Any additional flows can likely not be used in the West due to a lack of refining capacity, which has been slashed since the pandemic.
Without the spare capacity to process raw crude, the bottlenecks are unlikely to resolve any time soon. Moreover, operating rates in the US are in the nineties, an unsustainably high level that can’t be maintained for long.
The EU has the same difficulty, having dismantled large sections of its refining capacity in the last two years. In some ways, the EU is worse off because continental refineries do not have the technology to cater to high sulphuric Middle Eastern variety inputs.
Refinery Capacities and Broken Self-Adjustment
During the pandemic, there has been a decisive shift in refining capacity from the West to Asia.
Gasoline prices are poised to stay high with the demand pressure during the summer driving season beginning in the US, China’s unwinding of its prolonged lockdown, EU sanctions on 90% of Russia’s oil contracts, and the unending conflict in Ukraine.
In the US, to lower prices, it is crucial to bring refinery capacity back online.
However, this is easier said than done. Profit generation could take a decade. Even at currently elevated prices, projects are likely to not be financially viable as investors anticipate a slowing global economy and the possibility of a deep recession to drag down demand.
The current confluence of factors suggests that there is no easy fix to get more refined products to everyday Americans.
Oil prices and refining rates tend to be circular and self-adjusting. As demand rises, prices rise, supply responds and this brings prices down. When demand is low, prices stay low, supply falls, and this leads to an improvement in prices. Today, because there is an expectation of a deep fall in demand, this mechanism may be short-circuited, leading to prices staying elevated due to a lack of increased supply.
Ironically, an expected loss in demand, rather than accelerating a fall in price, may keep prices elevated by dissuading investments in refining capacity.
World-renowned energy expert, Dan Yergin believes that the US can improve its supply situation “but not overnight. In other words, it’s doable, but it takes a lot of coordination to make it happen.” This places the Biden administration in a difficult position, raising expectations of what the agenda during the Saudi visit may entail.
Is there room for prices to fall?
This is not likely in the short-term, at least not until a new OPEC+ agreement is negotiated later this year, surging supplies if Biden has a successful visit to the Kingdom or a sudden demand collapse in China.
The one major downside risk comes from the possibility of an all-out demand collapse due to a deep recession, with the Federal Reserve hiking into a bear market.
However, the credibility of the Fed is not what it once was, and the very real possibility of a reversal of policy normalization and quantitative tightening still looms large.
Another factor may be the wider use of ESG metrics and climate activism, which may slow new facilities from coming online in countries like the United States.
The wild card in the pack may be Germany, which is struggling with 8.7% inflation. Having experienced the horrors of hyperinflation in the 1920s, social attitudes are highly averse to inflation. Switching to a sustainable and cost-effective substitute for Russian energy supplies may prove more challenging than expected. It would be interesting to see if the implementation of the EU sanctions proceeds as planned towards the end of 2022.
Outlook
With the deep deficit of refining capacity among western countries, crude prices will stay elevated for the foreseeable future. If China can recover its growth, this could amount to an additional one million bpd of crude demand.
In a change of strategy and amid environmental concerns, China has been reducing its refined exports adding to the tightness.
Since yesterday, crude prices are running hot with WTI rising to $117 at the time of writing, while the EIA reported a sharp decline in gasoline inventories compared, and US crude inventories being approximately 15% below the 5-year historic average.
Global supply is only expected to get tighter with US plans of deploying howitzers and rocket launchers to Ukraine, fuelling concerns of an escalation in the region.
Amrita Sen re-iterated that on the ground, the OPEC+ agreement would only add “minuscule volumes” to market supply, and of course, side-steps the refinery issues.
In her view, with China coming out of lockdown, we are likely to see “1.5 million bpd of negative drawdowns in Q3, which we just don’t have”, meaning that “prices have to rise.”
With the rising demand and bottlenecks such as in US refinery labor supplies, prices will almost certainly rise to between $120- $130 as of the end of the OPEC+ agreement in August, with a possible upside as gasoline demand rises in the summer.
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Source: https://invezz.com/news/2022/06/06/did-the-russia-saudi-bloc-weaken-at-opec/