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Ross McCracken

Ross McCracken

Ross is an energy analyst, writer and consultant who was previously the Managing Editor of Platts Energy Economist

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Oil Markets Unbalanced By Brinkmanship

Trump

OPEC agreed in Vienna that it would roll over its 1.2 million b/d crude oil production cuts for another nine months, which would keep the agreement in place until end-March 2020.

On Tuesday, the oil cartel discussed the cooperation of non-OPEC producers, the key member of which is Russia. Both Saudi Energy Minister Khalid al-Falih and Russian President Vladimir Putin had already said at the G20 summit in Japan that they were in agreement on the rollover, so OPEC+ cooperation was more or less a formality.

The cuts promised by OPEC+ are already in place and there is little reason to expect any overall slippage. Saudi Arabia in May was producing about 600,000 b/d under its cap. Venezuela remains mired in an economic crisis that has severely eroded the operational capabilities of state oil company PDVSA. Iranian exports are strictly bound by US sanctions, and the Arab Gulf kingdoms will follow Saudi Arabia’s lead.

Other OPEC members have little spare production capacity. Iraq has been producing about 300,000 b/d above its cap and remains the compliance bad boy, but it is restricted by domestic infrastructural limits on crude production and exports. Russia’s output in the short term is curbed by the clean-up operations relating to the contamination of crude in the Druzhba oil pipeline.

Trade talks

The possibility of OPEC implementing deeper cuts was rejected largely on the basis of a softening of the US-China trade war. At the G20 summit, US President Donald Trump said that planned new tariffs would not be imposed on China. Trade talks are to resume. Trump even offered a concession on US sales to controversial Chinese tech giant Huawei.

The situation has reverted to one similar to the start of the year, but with the crucial caveats that six months have been lost and there is no guarantee that the resumed talks will not collapse again as they did in May. In the meantime, the world economic outlook has become gloomier as the impact of the tariffs already in place take their toll.

World economic growth is already slowing. The absence of more tariffs suspends an additional threat, it does not alter the despondent direction of travel.

Barriers to compromise

An end to the trade war requires both sides to cross lines drawn in the sand. The US negotiating position represents a challenge to the whole structure of the Chinese economy and to the ambitious modernisation path set out by Chinese President Xi Jinpeng.

Modernisation in the Chinese context does not mean market deregulation, but technological leadership. The state support for major industrial sectors - from steel to solar panels, electric vehicles, IT and AI - which the US is challenging, is an integral part of achieving that modernisation.

The US wants not just significant movement from China, but also mechanisms to ensure compliance. If presented via a multilateral body, like the WTO, such mechanisms can be framed as international rules, i.e. mutual cooperation, with independent verification and arbitration.

However, in the context of a bilateral Sino-US stand-off, concessions look like an affront to Chinese sovereignty. The US unilateral approach makes the discovery of a face-saving formula harder for both sides. The initial adoption of hard-line positions and their subsequent robust defence means compromise appears diplomatically more as a lose-lose than a win-win.

Optimism about the resumption of trade talks reflects the view that the political cost of damaged trade and slowing economies will start to outweigh the political gains of hard-line negotiating postures; the idea that ‘sense will eventually prevail’.

The downside scenario for the oil market is two-fold: either it takes more time, perhaps another six months, for sense to prevail; or alternatively, that what made ‘sense’ previously no longer applies, trade talks stall again, and both sides dig in for a long war of attrition.

US shale

The oil market has responded favourably to OPEC’s decision, with Brent pushing back up into the mid-$60s/bbl from a flirtation with $60/bbl in the early part of June. At this level, US shale production will continue to grow.

Falih’s comment that US oil output will peak and then plateau is questionable given the scale of the resource. The amount of ultimately recoverable oil is a function of both price and technology. It may be misguided to view US shale as a conventional oil resource that will uniformly follow a similar production path to the North Sea.

It is also a medium to long-term view that has little relevance to oil prices over the next three years. Even if US shale does peak and plateau, it is not expected to do so until the mid-2020s, by which time it may be supplemented by both Canadian and Argentinean shale production, even if the latter’s fortunes are heavily at risk from the coming presidential elections in Argentina.

Falih’s view also fails to take into account the possibility of peak oil demand. The Chinese-US trade war is an existing dampener on oil demand growth, peak oil demand is a more existential threat, but one which may become more evident coterminous with a peak in US shale production. The OPEC rollover is a short-term fix for today’s market conditions rather than a long-term strategy.

Iran/US

Trump is a man fighting wars on multiple fronts. Not only is he engaged in a trade war with China, but an even more tense stand-off with Iran. As OPEC talked, Iran was breaching its commitment on low-level uranium enrichment in the nuclear agreement reached with the P5+1 group of world powers from which the US withdrew.

Here again, hard-line brinkmanship on both sides appears to demand humiliating capitulation rather than compromise. Iran’s breaking of the nuclear agreement terms is unlikely to galvanise European or other opposition to the US position.

The stakes in this dispute are higher even than the trade war because there is a real risk of conflict, which would severely impact both crude oil and LNG flows from the Arabian Gulf. Recent attacks on tankers and Iran’s shooting down of a US drone in June were dangerous flashpoints.

Again, compromise would most likely occur through a multilateral or multiparty agency, but Trump doesn’t appear to do multilateralism. There appears to be very little prospect of movement on either side and the outlook is thus for an extended period of heightened Gulf tension, while sanctions take their slow and uncertain effect.

The US/Iran stand-off will add volatility to oil markets. OPEC’s rollover stabilises the supply-side of the market for the moment, but is another gift to non-OPEC producers because it will come at the expense of market share. Russia’s commitment to the rollover is uncertain as it is masked by short-term practical necessity. It may now be trapped long-term in its cooperation with OPEC, but it could also, in 2020, decide that it wants its free-rider benefits back.




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