Oil Games

OPEC unbound

Last week OPEC+ (OPEC members and non-member countries such as Russia) announced at a conclave in Vienna a plan to cut oil production by two million barrels per day (bpd). This would be the largest reduction in output since the apogee of the coronavirus pandemic in April 2020 when OPEC cut output by 9.7 million bpd in the face of crashing demand. Decision-making within OPEC is dominated by the two largest oil producers, Saudi Arabia and the United Arab Emirates (UAE). Significantly, Sheikh Mohammed bin Zayed-al-Nahyan, president of the UAE, met with President Putin in St. Petersburg on Tuesday (11 October).

The objective is of course to bolster the oil price which has been falling over the last month, having rocketed in the early stages of Russia’s war against Ukraine. This move represents a slap in the face to President Biden who made his pilgrimage to Saudi Arabia in the summer expressly to request its fist-bumping ruler, Mohammed bin Salman, to increase production. News of the production cut came just hours after the EU agreed to impose a price cap on supplies of Russian oil in a bid to deny Russia abnormally high revenues. The EU plans to stop importing all oil from Russia from December onwards.

In response to the news, the price of oil rebounded from around $80 to about $90 per barrel. At the time of writing, the price of Brent crude has firmed to $94.78 – around its highest level since late August. Let’s recall that the peak oil price was recorded on 8 March at $127.98. In the UK, petrol prices at the pump are beginning to edge up again, averaging out at 162.3 pence per litre for unleaded earlier this week. In France, strikes at oil refineries have reduced supply to petrol stations, pushing up prices across Europe. Unusually, there were also strikes at the Abadan refinery in Iran as part of the growing unrest in that country.

Bin Salman’s fraternisation with Putin has not gone down well with western nations which vigorously oppose Russia’s invasion of Ukraine. That said, none of Russia’s supposed allies – except for North Korea – has recognised Russia’s annexation of four Ukrainian provinces on 30 September, namely: Luhansk, Donetsk, Zaporizhzhia and Kherson. It is of note that China and Iran have failed to comment on Putin’s illegal annexation – one which, significantly, did not even attempt to demarcate the precise boundaries of those territories. Indeed, there are signs that China and India are now distancing themselves from Putin’s Russia. India has even called for a negotiated settlement.

The Saudis always claim that their oil policy is a matter of commodity-market management and is not a part of their geopolitical strategy: but in practice it is difficult to disassociate the two. Their claim this time that they simply wished to avoid excessive volatility in the oil price is specious. Their revenue projections trend downwards, with an expected recession in Europe, a likely mild recession in the US, and sluggish growth in China and much of the developing world. The Saudis brazenly moved to keep the oil price closer to $90.

For Biden, the oil price is politically sensitive because the price of gas (petrol) is an emotive issue in the mid-term congressional elections which will take place on 8 November – just three and a half weeks from now. Americans are now paying $4.03 a gallon for gasoline – that’s about 96 pence a litre in British terms, which sounds cheap this side of the ‘pond’, but is expensive enough for Americans to complain.

JP Morgan thinks that the US will respond by releasing more oil reserves onto the open market. One immediate outcome is that the US is preparing to ease the sanctions regime on Venezuela in order to induce the oil-rich country to pump more oil. Reportedly, the Biden administration would be willing to lift trade restrictions in exchange for a commitment by Venezuela to hold free elections within the next two years. Chevron already has a major presence in the country, and it is thought that it could ramp up production relatively easily to 200,000 bpd.

Venezuela has been a pariah for the Americans given its lack of cooperation in the war against the drug trade, its flagrant human-rights abuses, endemic corruption and the authoritarian dictates of President Nicolás Maduro. Any prospective elections would entail negotiations with Venezuela’s opposition. But with the new Colombian president, Gustavo Petro, re-establishing relations with Venezuela, and with Luiz Inácio Lula da Silva likely to win Brazil’s presidential election on 30 October, there is a change of political climate in Latin America. A recent prisoner exchange between the US and Venezuela is a positive development. And if the US were to allow Venezuela to increase oil production, the country could once again become a major global supplier.

The US is the world’s largest oil producer and the largest producer of shale gas. It has achieved energy independence – something which eluded previous generations of Americans. Europe is far more vulnerable to the machinations of a producer cartel. That said, Europe and the UK have plentiful and growing supplies of renewable energy. That, slowly but surely, means that Europe is freeing itself from OPEC’s caprice. Europe’s consumption of crude oil has been dropping at an average annual rate of 0.4 percent since 2000. Moreover, the UK is now going to start fracking again and drilling for oil in the North Sea – unless that initiative is stymied by Tory rebels in the House of Commons. This move by OPEC will only entrench Europe’s determination to become less dependent on imported oil.

OPEC does not have as much power to sway the world economy as it did back in the 1970s. Even Bin Sultan knows that the oil industry is in long-term decline – though it will continue to be with us for some time to come. On Tuesday, Biden said that there would be “consequences” for Saudi Arabia given its pivot towards Moscow, and its timing – presumably, in the first instance, in the form of a cessation of arms sales. But then if the US stopped selling arms to Saudi Arabia, no doubt the Russians would try to fill the vacuum – though their munitions brands do not exactly fly off the shelves right now.

There is also talk in Washington of reviving the regime of anti-cartel legislation such that the US justice department could sue OPEC + and its state-controlled oil companies under antitrust laws. There is already wide support for this amongst Republican senators.

The relationship between the US and Saudi Arabia has been described as “energy-for-security” and yet that has not been the case for years since the US no longer imports a single barrel of oil from Saudi Arabia. The country has long since been a problem for the Americans – most of the 9/11 conspirators were Saudi-Arabian nationals and the desert kingdom is known to export its unyielding brand of Wahhabi Islam around the world, fuelling Islamic insurgencies all over.

This puts the entire geopolitical landscape in the Gulf region in flux. And if the Islamic Republic of Iran were to fall, as could happen now − though most analysts think it unlikely − Saudi Arabia would be entirely surplus to US security requirements. Consequences, indeed.

Europe: keeping the lights on

Meanwhile, the Europeans seem to have made unexpectedly rapid progress in their efforts to wean themselves off Russian hydrocarbons. Although Europe now faces winter – and we don’t yet know if it’s going to be a cold one – the EU bloc has managed to maintain gas-storage facilities at critical levels, despite much reduced flows of Russian gas.

According to the Oxford Institute for Energy Studies, Russia sent an average of 490 million cubic metres of natural gas to Europe per day in September 2019; but last month that figure was down to 80 million cubic metres per day – even before the Nord Stream 1 and 2 pipelines were sabotaged by as yet unknown agents on 26 September. I won’t get into speculation here as to who was responsible for that – except to say that the conspiracy theorists have been working overtime on social media.

Thus, the energy challenge is not as bad as was first feared. This is firstly because the EU has taken delivery of new supplies of liquid natural gas (LNG) from North Africa and beyond: Germany is about to launch five new floating LNG terminals in record time; and the Eemshaven terminal in the north of the Netherlands is receiving LNG at scale from the US. And secondly, because the EU has set out to reduce consumer demand by at least 15 percent (unlike the UK where the Truss government seems to have an ideological objection to “nannying” consumers).

That said, the overall spike in energy prices risks sending Europe and the UK into recession over the winter. In a cold winter gas consumption can be expected to spike; and a cold winter with large high-pressure weather systems could also entail less wind power, leading to the possibility if not likelihood, of power outages. Nevertheless, most analysts expect gas prices to fall over the winter. Goldman Sachs has predicted that gas prices will fall to half their current level − to about €100 per megawatt hour. Contract prices have already started to fall in the gas futures market.

This is welcome good news for the Truss government since the Energy Price Guarantee scheme – much vaunted by the new prime minister – is likely to cost about half what was envisaged at the time of the “mini-budget” (aka ‘kamikaze budget’) of 23 September. The scheme caps energy prices at £2,500 for average household consumption − but if energy prices fall by 40 percent from current levels the cap may not be needed at all. The Treasury can also expect to garner additional tax revenues from the fiscal-drag effect caused by freezing tax bands as wages and salaries rise with inflation – but that is another story.

Back in Russia, excess unsold gas is being kept in storage facilities. Russia lacks the infrastructure to offload all its unsold gas to China – there is currently just one cross-border pipeline which is operating at full capacity, though there is another one under construction. There have been reports of ‘flaring’ − where producers just burn off surplus gas which cannot be stored – a waste of resources that also generates unnecessary carbon emissions. If this situation continues indefinitely, as seems likely, Gazprom may be forced to cut production and to seal up wells for good. Within just six months Putin has destroyed Russia’s 50-year reputation as a valuable and reliable energy supplier to Europe. That status will probably never be restored − though it is too early to speculate on what Russia will look like once the war is over.

Kristalina Georgieva, the managing director of the IMF, has suggested that Europe could face widescale unrest if there is a harsh winter with electricity blackouts. The EU has already unveiled a plan to tax oil and gas producers’ “surplus profits” at a rate of 33 percent. It has put price caps on the sale of electricity from nuclear plants, solar arrays and wind turbines – and the British government announced something substantially similar on Wednesday this week (12 October).

Europe’s energy crisis has been exacerbated by the travails of France’s nuclear sector and by low hydropower reservoirs resulting from last summer’s drought. Six of France’s 56 nuclear reactors have been out of service since the early summer with the result that the UK has become a major exporter of electricity to France. According to the National Grid Status Monitor 5.64 percent of total UK power output is being sent to France this morning.

The US: gas exporter to the world

US gas exports used to consist of relatively small volumes sent by pipeline north to Canada and south to Mexico. In the last 15 years that has changed as the shale boom, starting in the Permian basin in Texas, was rolled out across the country. The US became a net exporter of gas in 2017 for the first time since the 1950s. During the first half of this year, the US overtook Qatar and Australia to become the world’s largest exporter of LNG at a rate of about 11.2 billion cubic feet per day. The US overtook Russia as the largest gas supplier to Europe for the first time in July. Centrica, the owner of British gas, recently signed a 15-year deal to import one million tonnes of LNG a year from a new floating terminal in Louisiana which is scheduled to become operational in 2026.

While gas in the US remains cheap by European standards, prices have been climbing. Gas is relatively expensive in the northeast of the country. There is some evidence that export gas has been withdrawn from domestic consumption because it commands a higher price. That has reduced overall supply. In February, just before Russia invaded Ukraine, a group of senators urged the Biden administration “to limit US natural gas exports and examine their impact on domestic energy prices”.

US domestic politics will be pivotal to the outcome of the Russia-Ukraine conflict. That is because the MAGA (Trumpian) wing of the Republican party is potentially divided on the issue. The question is being asked as to why the US should pay billions of taxpayers’ money to support a “corrupt” Ukrainian government (with which the president’s son, Hunter Biden, had links), suffer rising energy prices and potentially start a nuclear war with Russia when a peace deal could be brokered along the lines of that recently floated on Twitter by Elon Musk.

Therefore, the main threat to the so-far solid western coalition against Russia comes not from Europe but from the US. We can expect calls for a ceasefire in Ukraine as a prelude to a negotiated settlement if the MAGA Republicans retake the House of Representatives on 8 November. I’ll consider what a putative “peace deal” might look like shortly.

The UK: renewable reliance

The UK has made huge progress in renewable-energy production over the last decade or more and can claim to be a world leader in wind power. That said, the UK wind-power sector is overwhelmingly dependent on foreign investors and suppliers. The five biggest developers in the UK of wind-turbine arrays are: Orsted (Denmark), Vattenfall (Sweden, state-owned), Iberdrola (Spain), Innogy (Germany) and Equinor (Norway). The hardware comes mostly from Siemens (Germany) and Vestas (Denmark). Together, these five players control about 70 percent of the UK wind-power market.

One thing that Russia’s war in Ukraine has taught us is the danger of being overly reliant on foreign energy suppliers. That lesson applies as much to renewable energy as to imports of hydrocarbons.

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PS I did my best to spare readers another digression into the ongoing saga of the UK’s economic policy this week. It is difficult for investors to avoid the matter, however, with the pound gyrating in an ungainly fashion and UK gilt yields lurching upwards with unpleasant consequences for the nation’s public finances. It seems that Tory MPs don’t think much of Liz Truss, the IMF does not care much for Kwasi Kwarteng and the bond markets have fallen out with Andrew Bailey.

And it is extraordinary that pension-fund managers had not stress-tested their gilts portfolios for a 100-150 basis point rise in gilt yields, which has been on the cards since at least the early spring of last year. I shall have more to say about that soon.

The halcyon days of ‘Captain Boris’ strutting around on the bridge guffawing at seagulls with dutiful helmsman Rishi at the tiller seem like a distant memory. Those who undid Boris will have been reminded of a wise and ancient idiom: be careful what you wish for.

Listed companies cited in this article:

• Chevron Inc. (NYSE:CVX)
• Centrica PLC (LON:CAN)
• Orsted (CPH:ORSTED)
• Iberdrola (BME:IBE)
• Innogy (EGR:IGY)
• Equinor (NOR:EQNR)
• Siemens (ETR:SIE)
• Vestas (CPH:VWS)