The future of oil prices

Given continuing US-Iran tensions and the production cutbacks by Opec and non-Opec producers, oil prices are likely to remain high even in the event of a global slowdown

Opec’s decision on December 7 to cut production to shore up crude oil prices was expected. Whether this will have the intended effect is not clear. The reduction will go into effect in January 2019. The immediate spurt in price is due to the loss of 400,000 barrels per day (bpd) of Libyan exports, as the El Sharara field has fallen into rebel hands. The incident points to continued fragility of the situation, since Libyan production accounts for 1.1 million bpd.

The fall in crude prices has relieved the pressure on oil importing countries for now. However, oil prices are driven not only by the demand-supply equation, but also by the geopolitical situation. This remains tense. On the eve of the Opec meeting, Iranian President Hassan Rouhani stated: “If it (US) wishes to halt Iran’s oil export, then no oil will be exported from the Persian Gulf.” This is the second time in recent months that he has made such a 

strong statement.

After peaking at $84.09 on October 4, crude oil prices began a downward trajectory as US Congressional elections approached. Whether or not the timing was a coincidence, over-production led to a softening of prices, which fell 10 per cent to $75.51 by the end of the month. However, the average of $79.39 for the month remained the highest since October 2014. 

The trend towards lower prices was reinforced by exemptions granted to eight countries from US sanctions, which went into effect on November 5. During the month, Opec production averaged 32.96 million bpd, driving oil prices down from $72.64 to $58.33 per barrel. The monthly average of the Opec reference basket for November registered a fall of $14.08, or 17.7 per cent, to reach $65.33 per barrel. This was the lowest price since March 2018.

Opec, accounting for 40 per cent of world crude oil production, needs coordination with non-Opec producers led by Russia to set the production level, and indirectly influence prices. Both Opec and the larger group — Opec+ — met in Vienna on December 7 and decided to reduce production by 1.2 million bpd below the October 2018 level. Of this, Opec’s share of the cut was 800,000 bpd, while non-Opec producers led by Russia agreed to reduce their production by 400,000 bpd. Russia agreed to reduce output by 230,000 bpd, while Saudi Arabia agreed to cut production by 250,000 bpd.

Saudi Arabian Oil Minister Khalid al-Falih talks to journalists at the beginning of the Opec meeting on December 6 in Vienna, Austria. The Saudis decided to cut oil output by 250,000 barrels per day

The diminished role of Opec in deciding the crude oil production level is accompanied by a shift in the role of swing producer from Saudi Arabia to Russia and the US. Swing production is a function of two factors: Spare capacity and the minimum price needed to balance the budget. Though Saudi Arabia may have spare capacity, it is constrained by the need to have a minimum price of $88 per barrel to meet its budgetary demands. Russia can meet its budgetary requirements with a lower price of $53 per barrel, and hence enjoys more flexibility. Any reduction in crude production by Opec+ brings in increased shale oil supplies. In the case of US shale oil, the floor is set by production cost. This however, has been progressively coming down and may have reached $40 per barrel according to some estimates. 

The Opec+ meeting coincided with two developments. First, Qatar announced that it would quit Opec in January. With an output of 600,000 bpd of Opec’s ceiling of some 32 million bpd, Qatar’s exit may not have appreciable effect on oil prices. Its production will not be constrained by the Opec quota. However, Qatari gas is indexed to the oil price, and hence its revenue realisation from export of LNG will be affected by Opec policies. Its decision therefore appears driven by politics, not economics. It is trying to distance itself from Saudi policies. If its decision becomes a precursor for Iran to move out of Opec, this will be a major blow to the Saudi Kingdom. As of now, this seems unlikely. Iran has been exempted from the production cut announced by Opec. Despite tense political relations with Saudi Arabia and increasingly bitter public rhetoric, it has an interest in maintaining the cartel, which keeps crude oil prices high.

The second development was the announcement that for the first time since 1949, the US has turned into a net oil exporter. US shale oil is light crude; it does not replace heavy or medium crudes produced by the Gulf countries and Iran. However, the ability of shale producers to quickly ramp up production does affect Opec. The relatively high production cost limits shale oil production once crude prices start coming down. Shale oil can limit the upside gains for Opec and non-Opec producers; it cannot replace them. 

Iran has been exempted from the Opec production cut. The US sanctions have already reduced Iranian crude exports, though the waiver to eight countries importing Iranian crude may have lessened the severity. Lower crude prices will compound the effect of reduced export volume. 

Geopolitical tensions in the region remain high. The bonanza for consumer countries in terms of lower crude prices will disappear in case the US waiver given for oil imports from Iran is withdrawn, or if volumes are further curtailed. The cut announced in the last Opec meeting, of 800,000 bpd below the October 2018 level of 32.976 million bpd, will bring the production level down to 32.176 million bpd. This will be lower than the output of 32.195 million bpd in the second quarter of 2018, when the upward streak in crude oil prices began.

The Opec cut is synchronised with a cut by non-Opec producers of 400,000 bpd. Whether US shale oil production can be ramped up further to compensate for an Opec cut of this magnitude is difficult to say. Even assuming a slowing down of the world economy and of growth in oil demand next year, the policies of Opec+ countries will keep the prices high.  

  The writer is India’s former Ambassador to Iran, and a Senior Fellow at Vivekananda International Foundation