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Who's your swing producer now?

Under pressure from Trump, Saudi Arabia has demolished the Opec deal and will now pour oil into a market that is suddenly running short

Late in the evening of 21 June, Bijan Namdar Zangeneh, Iran's oil minister, walked out of Opec's headquarters on Helferstorferstraße and rushed to the nearby Kempinski hotel. He unloaded on the waiting press pack, briefing Iranian journalists off the record. Iran would accept no deal to increase oil output at the next day's Opec meeting, he said. Doing so was tantamount to "suicide", he told the Iranian reporters. The Opec meeting seemed destined for an ugly confrontation, the climax of a week of high-stakes petro-diplomacy.

While Zangeneh huffed, a crucial meeting carried on without him back in Opec's headquarters. The Joint Ministerial Monitoring Committee (JMMC), led by Saudi Arabia and Russia, was set up last year to ensure compliance with the cuts agreed in the Declaration of Cooperation between Opec and non-Opec producers. Now the JMMC was proposing that the cuts start to end. It put forward three options for the 22 June Opec conference: an output rise of 1m barrels a day, 1.5m, or 1.8m.

Zangeneh, not a member of the committee, had asked to attend. Like everyone else, he knew Saudi Arabia's policy had shifted. Donald Trump's White House was demanding more oil. But Opec needs unanimity to change its plans—and Iran had conditions it wanted met if Zangeneh was to vote even a modest increase. It wanted Opec's communiqué the next day to "condemn"—he insisted on the word—US sanctions on Iran. Raising production was tantamount to doing the White House's bidding, he had suggested in the days earlier. "Opec is not an organisation [set to] receive instruction from President Trump and follow it."

But when he tried to address the JMMC members, Saudi energy minister Khalid al-Falih denied him the floor. Zangeneh walked out. Falih was said to be worried that he'd offended his Iranian counterpart. They met the next day before the Opec meeting proper, apparently to iron things out.

700,000 b/d—Libyan production thought to be at risk

They needn't have bothered. Saudi Arabia has emerged with what it wanted from the Opec meeting—and more. Iran thought it had won a minor victory in the meeting, but has been left as the fall guy. As the dust settles on the Opec and non-Opec meetings of 22 and 23 June, it is clear the cuts are dead. Opec didn't condemn sanctions on two of its founder members, Iran and Venezuela. The pretence of group unity has been shattered.

A supply free-for-all—maybe better described as a free-for-some—is underway. The Opec+ producers that are able to produce more will now max out. Russia will pump hard: its energy minister, Alexander Novak, says another 170,000 b/d will come by the end of the year; its companies itch to produce even more. Saudi Arabia says it will imminently lift output to 11m b/d—its highest ever level and at least 1m b/d more than it averaged in 2017.

Even that may not be enough, because the supply losses are mounting steeply. As it stands, the oil market will enter the second half of the year—its seasonal demand peak—facing deepening disruptions from Iran to Nigeria, Venezuela to Angola. Just a few months ago, oil executives were still talking of oil's "lower-for-longer" price outlook. Now a price shock may be imminent. Saudi Arabia and the other Gulf producers get the best of all worlds: selling into a rising market craving more oil.

Not what was agreed

Opec members knew about the supply problems when they met on 22 June (the meeting with non-Opec followed a day later) and that the time had come for more oil. But the communiqué afterwards only said the group would "strive to adhere" to 100% compliance with its cuts. This implied an increase in output, but with no real production numbers. Pressed for details, Suhail Mohamed al-Mazrouei, the UAE's energy minister and current Opec president, said that "the actual production of each country is something unilaterally they can decide". Did that mean countries would exceed their quotas to make up for those that couldn't? "You do the math," Mazruouei said.

It was a "classic Opec fudge", admitted one senior official from the organisation. Iran seemed to have prevented the supply surge sought by Trump, though no mention was made in the communiqué of sanctions. (A paragraph was prepared calling for the "depoliticising" the oil market, but it was nixed). The vagueness of the wording meant different producers offered different interpretations of what had been agreed. Falih said it allowed for a supply hike that would be "closer to 1m b/d than 600,000", while Zangeneh said Opec wouldn't add more than 500,000 b/d.

The market's reaction was swift—and unexpected. WTI rose by 5% in the hours after the meeting, to almost $69 a barrel, Brent by more than $2, to $75.55/b. The market had moved in the wrong direction.

Ear to the ground: energy minister Alexander Novak says Russia will pump another 170,000 b/d by the end of the year

It was not the outcome sought by the US government either. Saudi Arabia's policy shift was plainly a response to what Falih had described in the weeks running up to the Opec meeting as consumer "anxieties". This was a reference to India and other big buyers of Saudi crude—but also a nod to Donald Trump, whose shadow loomed over the Vienna summit.

Through the first quarter of 2018, things had been going according to the Saudi plan—and it did not include more supply. The global stock overhang was being eliminated thanks to strong oil-demand growth and the Opec+ cuts. To keep momentum going (and protect the price gains), Falih started talking of the need to find a new metric to assess Opec's success. No longer five-year-average OECD stock levels, but maybe a seven-year measurement, or a gauge of upstream investment. No one in Opec wanted to end the cuts prematurely and risk another price slump.

Then, during the press conference after a JMMC meeting in Jeddah on 20 April, Trump waded in, tweeting that oil prices were "artificially high" and that Opec was "at it again". It caused panic within Opec, say people in the organisation. Privately, senior US officials followed it by pressing Opec's core Gulf producers for more oil supply—they wanted 1m b/d extra, a specific number that apparently came from high up in the US administration, according to sources.

The Opec narrative suddenly shifted. By the time Falih attended an investment conference in St Petersburg in late May, he was openly talking of more supply. Russian President Vladimir Putin added his voice, saying that Russia would be "perfectly happy" with $60/b oil. The plan was set—only the size of the increase remained to be decided. It seems plausible that Jared Kushner, senior advisor to his father-in-law Trump, could have shared the White House's view again in a chat with Saudi crown prince Mohammed bin Salman in Riyadh two days before the Opec meeting.

Demolishing the deal

Like the market, the US' disappointment with the outcome in Vienna was swift. Trump tweeted again, hours after the Opec meeting ended, hoping for a "substantial" increase from the producers. A couple of days later, US energy secretary Rick Perry declared that Opec's planned increase "may be a little short of what is needed".

Stung by the unexpected price rise and the US reaction after the meeting, Saudi Arabia doubled down. The private briefings began within hours—the market would be surprised at the volume of oil, they said. Then, as if the Opec agreement was already in the distant past, on 26 June Saudi sources told newswires that the kingdom would increase output to as much as 11m b/d from July. Not even Ali Naimi, the former Saudi oil minister who in 2014 opened the taps in a failed attempt to curb tight oil growth, had been so bold. After just four days, the Opec fudge had melted away. For members that left their 22 June meeting believing they had agreed only a modest supply increase, the Saudi power play will leave a lasting impression. Back in Tehran, MPs talked of betrayal.

Trump has also doubled down with his demands since the Opec meeting. On 30 June he tweeted that King Salman had "agreed" to adding "maybe up to" 2m b/d of oil. Then, in an interview with Fox on 1 July, he let the cat out of the bag about his quid pro quo with the kingdom. "Who's their big enemy? Iran," he said. "So they're going to have to put out more oil." Opec was "100%" manipulating the market, he said, even though the US was "protecting many of those countries".

In retrospect, the crux point came on 8 May, when Trump pulled the US out of the Iran nuclear deal and reinstated sanctions on its oil sector. Satisfying a key strategic Saudi objective—Iran's economic and diplomatic isolation—gave him leverage with a kingdom already eager to secure its alliance with Washington. The art of the deal is that as Iranian oil is removed from the market, Saudi supply will rise to mitigate the price impact.

Having got his way with Opec, Trump and other consumers now need the supply surge to work. Yet despite the Saudi pledges, the market continued to rally. Brent was homing in on $80/b as Petroleum Economist went to press for the July/August edition. The market still doubts that production will rise sufficiently to loosen a market facing mounting outages elsewhere (see table).

Supply surge, disruption surge

The disruptions, current ones and coming ones, are certainly building—and US policy is to blame for the biggest. On 26 June, the US State Department said its "disposition" was not to grant any sanctions waivers to importers of Iranian oil—as the Obama administration had—and that it would take measures against purchasers who don't reduce their imports to zero by 4 November. Already, about 500,000 b/d have been lopped off Iran's exports, according to tanker-tracking analysts, but the US wants the remaining 2.2m b/d gone as well. Trump already seems to have persuaded even India to stop importing from Iran, though China may hold out. But the aggressive US position means Iranian supply losses could reach much more than 1m b/d of supply.

In Libya, conflict in the Oil Crescent in recent weeks has cut supply by 450,000 b/d. But this too may be just the start. More output is at threat after Khalifa Hafter's militia, the Libyan National Army, regained control of the area and its energy infrastructure but handed over the assets to a breakaway unit of the state oil company. The eastern National Oil Corporation has no legal remit to sell Libya's oil. Hafter's move may be a bargaining ploy—but it risks escalating Libya's conflict and shutting the bulk of its onshore oil output. Another 250,000 b/d is under threat.

The oil market's true basket case remains Venezuela. Its production, at 1.36m b/d in May, is already 700,000 b/d beneath its level at the end of 2016. PdV, the state oil company, is now unable to make cash calls. Bond payments, both PdV's and sovereign ones, are due later this year. The vortex looks inescapable. Output could fall beneath 1m b/d by the end of this year, compared with 1.36m b/d in May, according to the International Energy Agency.

And then come the fringe, perpetual disruptions—the kind a loose oil market could take in its stride. But no longer. Nigeria's production was down 150,000 b/d in May, according to Platts, and Angola's hit a 19-month low, to 1.5m, 200,000 b/d less than it averaged before the Opec cuts started. Even stalwarts like Canada are chipping in: an outage at the Syncrude oil sands facility in June removed 360,000 b/d from an already tight heavy oil market.

Straitened capacity, straitened consumers?

Even more problematic is that the Saudi supply surge, if it is truly to be sustained at 11m b/d, brings its own bullish tail risks too. Opec's spare capacity was already thinning. The Energy Information Administration says it was just 2.45m b/d in the second quarter (including the 550,000-b/d Neutral Zone). Almost all of this resides in the Gulf Opec producers that are now going to start raising output. Even before this supply hike began, total spare capacity was edging towards the low levels that helped cause the 2008 price spike.

Something will have to give. If a leap in Saudi supply (and from the Neutral Zone it shares with Kuwait, which the countries will now surely start to reactivate) doesn't do the trick, a price rise will have to ration demand. Forecasters don't expect this yet—the IEA thinks consumption will rise again by 1.4m b/d in 2019. But protests against rising fuel costs in India (where the removal of subsidies in recent years has exposed consumers), China and Brazil show consumer discontent is spreading. Gasoline prices in the US are already 26% higher now than a year earlier, according to the Automobile Association of America.

And that's before the recent rally in crude oil prices feeds through, before the market kicks into a higher demand phase in Q4, and before the Iranian sanctions really start to bite. Don't be surprised as talk of a release from the US Strategic Petroleum Reserve gains ground ahead of the November mid-term elections. The days when American shale would guarantee endless cheap oil prices have ended. Now Trump and everyone else will see if Saudi Arabia can reassert its swing producer role again.

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