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The Law of Unintended Consequences

The announcement of U.S. sanctions against Iran has had an unwanted and seemingly unexpected effect: increased Saudi and Russian influence on the international market

by Nazrin Mehdiyeva
21 January 2019
15 min read
byNazrin Mehdiyeva
21 January 2019
15 min read

Predicting international oil prices is a dangerous business. In 2018, geopolitics dominated market discussions with a vengeance. A plethora of factors have demonstrated that despite the “tsunami of shale” from the United States, the geopolitics of oil will remain paramount to understanding the market.

Random vs premeditated

Geopolitical factors that affect the oil market can be classified broadly into two categories. The first are unpremeditated events, which are inflicted on the global market as a result of internal crises within states, instability and regime change, armed conflicts or terrorist activities. As in every year, examples of such events in 2018 abounded. Among the most notable were attacks on pipelines in Nigeria, which led to the loss of 150,000 barrels per day (bpd) of Bonny Light crude and a declaration of force majeure on exports; the loss of 850,000 barrels per day in shipments from Libya after the forces of military strongman Khalifa Haftar recaptured ports and transferred control over them from the U.N.-backed government in Tripoli to a separate entity controlled by the self-styled Libyan National Army in Benghazi; and, the deepening crisis in Venezuela, which led the output to collapse to around 1 million bpd from nearly double that volume a year earlier.   

The second category of geopolitical factors comprises those events that are calculated and intentional, such as military interventions, sanctions and output quotas. In 2018, the most prominent examples of these included the U.S. withdrawal from the multilateral nuclear treaty with Iran and the reimposition of sanctions; the decision by OPEC states and their non-OPEC allies to increase production ahead of the U.S. sanctions notwithstanding the opposition from Tehran; and the waivers on the import of Iranian oil granted by the U.S. Treasury hours before the sanctions regime was due to come into effect.

Intentional actions with unforeseen effects

Despite being purposeful and announced in advance, the premeditated geopolitical interventions in the market frequently produce a range of unforeseen consequences. Consider Saudi Arabia’s “pump-at-will” policy. Championed by Saudi Energy Minister Ali al-Naimi between 2014 and 2016, it sought to drive U.S. shale producers out of business by collapsing the oil price. During this time, Riyadh stopped coordinating output within OPEC and instead flooded the market with additional oil. While this policy forced many U.S. shale producers into administration, those that survived did so by cutting costs below what had been previously thought possible for unconventional hydrocarbons producers. This outcome was contrary to the original intent of the Saudi intervention and, despite a policy reversal in 2016, it has continued to shape the market.

By mid-2018, the lean and increasingly competitive U.S. shale survivors had grown to represent half of U.S. oil production, a massive increase from the meager 10 percent that they contributed in 2011. Indeed, the United States hailed a key milestone of 11.3 million barrels per day in August, when U.S. production was higher than that of Saudi Arabia and Russia, which in that month reported daily output at 11.2 million and 10.4 million barrels, respectively. Propelled by gains in shale output from the Permian basin and the Bakken field, the threshold of 11 million barrels per day was reached sooner than expected by the U.S. Energy Information Agency, which has since revised its U.S. production forecasts upwards. According to the new set of data, U.S. crude output is expected to add 1.1 million barrels per day by the end of 2019, increasing average daily output from 10.9 million to 12.06 million barrels. The United States is thus on the path to become the world’s largest supplier of crude, overtaking Russia and Saudi Arabia.

Yet in recent analysis, the executive director at the International Energy Agency, Fatih Birol, has argued that shale alone could not be relied on to head off global shortages, which would result from the current low level of investment in conventional reserves and growing demand. The IEA’s latest Word Energy Outlook, published in November, predicts energy demand to grow by more than a quarter between 2017 and 2040. This figure doubles if no improvements are made to the current levels of energy efficiency. At the current levels of investment in conventional reserves, shale producers would have to raise output equivalent to “one Russia” in the next seven years if they are to stave off supply shortages. That, in Birol’s words, would be nothing short of a “small miracle.”

The power to swing

Despite the massive output gains, the U.S. has not emerged as a swing supplier to the market. Pipeline congestion has created a situation where strongly growing output cannot be transported out of the production region, and, even when additional volumes are evacuated by rail car and trucks, a related problem of insufficient export infrastructure means that the United States is constrained in the volume of crude that it can ship to global markets. These bottlenecks prevented U.S. producers from delivering larger crude volumes internationally when oil prices began to rise following production cuts by OPEC and non-OPEC states in 2016-17. They continued to act as a constraint in 2018 when prices spiked at over $86 per barrel in October, as the market braced for hard sanctions on Iran. Repeated demands from the White House, communicated most frequently by President Donald Trump via twitter, that Saudi Arabia and Russia increase production to keep a lid on prices was tantamount, in the view of Moscow and Riyadh, to U.S. acknowledgement of its inability to balance the market.

As the main states in the system with spare capacity, Saudi Arabia and Russia increased their cooperation. Deemed unthinkable less than four years ago, the two states publicly flaunted their “complete alignment” of interests at the OPEC meeting with non-OPEC allies in June. Between May and late September, OPEC output had been raised by almost 1 million barrels per day, despite falling supply from Iran and Venezuela. Russian production too was growing, reaching a new post-Soviet record every month. Yet the psychological impact of the impending U.S. sanctions on Iran was a driving factor that raised Brent prices to $86 per barrel in October - their highest level since 2014.

The unwanted, and seemingly unexpected, consequence of Trump’s announced decision for a “zero-tolerance” sanctions regime on Iranian oil increased Saudi and Russian leverage in the international market. While Riyadh had long played the role of a swing supplier on the global scale, Moscow was less accustomed to the limelight. For its senior officials, this was a chance to tout Russia’s “responsible partnership approach,” in which Russia increased output to help balance the tightening market. The contrast was made with the United States whose “irresponsible policy,” Russian officials said, produced higher prices. In their assessment, the prices within the $60-$80 per barrel range, which President Donald Trump found unacceptably high, suited Russia just fine. In analyzing the root cause of the higher prices in October, President Vladimir Putin stated that “the activities of the U.S. administration” were to blame, most notably the expectation of sanctions against Iran, political problems in Venezuela and the destruction of the state in Libya. He declared that Russia would be prepared to continue to grow output - from the post-Soviet record of 11.4 million barrels per day achieved in October - thanks to newly developed East Siberian fields, such as Rosneft’s Yurubcheno-Tokhomskoye, Taas-Yuriakhskoye and Suzunskoye.

Rhetoric and defiance

Moscow also felt vindicated in its argument that U.S. sanctions represented an act of geopolitical interference in the market and a means of economic warfare designed by Washington to promote the export of U.S. shale hydrocarbons. This argument, first postulated following the imposition of U.S. sanctions on Russia in the aftermath of Moscow’s illegal annexation of Crimea in 2014, became entrenched in the Kremlin’s rhetoric. It appeared to receive more credence internationally following the announcement of the sanctions on Iran in May, particularly as U.S. Treasury delegations began to negotiate the sale of U.S. crude to India and China, to replace Iranian supplies before the imposition of sanctions in November. Indeed, U.S. oil exports to India soared to record highs of 347,000 barrels per day in June, rising from 8 million barrels in all of 2017 to 15 million in the first seven months of 2018.

Yet, in the following months, the attractiveness of U.S. crude diminished due to the strengthening of the U.S. dollar and the reduction of the Brent premium to WTI. Tehran’s decision to offer insurance on cargo and tankers operated by Iranian companies as well as oil discounts also played a role. Speaking in October, Indian Oil Minister Dharmendra Pradhan stated that India would continue to purchase oil from Iran following the end of the sanctions’ wind-down period on 4 November. Pradhan added that India was considering setting up a payment system to buy Iranian oil using Indian rupees. The sentiment was shared by the E.U., which also suggested setting up a Special Purpose Vehicle to “facilitate legitimate financial transactions” with Iran, including those in oil. Russia continued to denounce U.S. sanctions as unilateral and illegal, insisting that it would continue to trade with Iran post-November.

China, which on average took 377,000 barrels per day of U.S. crude in the first seven months of 2018 and ranked as the first or second (after Canada) top destination for U.S. crude, responded to the escalating trade war with the United States by dropping U.S. oil imports to zero in August. Even after Beijing excluded crude from its list of tariffs, Chinese importers did not purchase any U.S. oil amid fears that the exclusion was temporary and implemented only to facilitate the delivery of those cargos to which the parties had already committed. To make up the shortfall, Chinese importers turned to other suppliers, including Iran, shipping in a record 874,000 barrels per day of Iranian crude in August.

Chinese refiners pointed to contractual obligations with Iran as a reason to continue buying Iranian crude throughout the rest of the year, while the country’s Foreign Ministry issued a statement asserting the “reasonable” nature of Beijing’s ties with Tehran, which were not in breach of U.N. resolutions. Indeed, an unprecedented volume of 22 million barrels of Iranian crude was loaded on the supertankers of the National Iranian Tanker Co for delivery to the Chinese northeast port of Dalian in late October and early November. This was far in excess of the monthly volumes of between 1 million and 3 million barrels of Iranian crude that the port has typically received since 2015. The move was clearly in anticipation of looming U.S. sanctions and aimed at using Dalian’s vast commercial storage facilities for subsequent sale to Asian customers, as was the case in the last round of sanctions in 2014. 

As the November deadline approached, the Administration’s position of imposing zero-tolerance sanctions on the purchases of Iranian oil became untenable. This led to the issuance by the U.S. Treasury of “temporary” waivers, which were granted to all major buyers of Iranian oil, including China and India. The adoption of “soft” sanctions was a face-saving measure for the Administration in the light of its inability to enforce the initially proclaimed policy.

The Saudi Dilemma

The waivers undermined the U.S. stance and complicated life for Saudi Arabia as the kingdom had raised production to record levels, pumping 11.3 million barrels per day in November. In conjunction with record-high production in Russia and the U.S., waivers resulted in a steady decline in the price of Brent from $73 per barrel on 5 November - the day when the sanctions went into effect - to under $60 by the end of the month. To balance its budget, Saudi Arabia needs international oil prices to average $73 per barrel in 2019. While this break-even point is lower than the $83 per barrel in 2018, in the situation of oversupply, created by the combination of soft sanctions on Iran and record-high oil output from Saudi Arabia and Russia, it means that, to balance the market, Riyadh needed not only to cut its own production but also convince other players within and outside OPEC to follow suit. This was achieved on 7 December in Vienna when OPEC and their non-OPEC allies agreed to cut production by 1.2 million barrels per day for six months starting in January. Russia’s Energy Minister stated that his country’s production would fall by 228,000-230,000 barrels per day, or about 2 percent. The agreed reductions are very close to the 1.3 million barrels per day cuts recommended ahead of the meeting by OPEC’s Economic Commission Board but went against the wishes of President Trump who demanded no change in production and lower prices.

The U.S. Dilemma

The timing of U.S. sanctions on Saudi Arabia would be hard to get right. On the one hand, announcing tough measures but watering them down later, the way the Administration was forced to do in the case of Iran, would damage the U.S. reputation. On the other hand, introducing tight sanctions before U.S. export infrastructure is expanded sufficiently for shale producers to deliver additional volumes to the market would lead prices to skyrocket internationally and hurt the U.S. economy, because U.S. prices at the pump continue to be set by developments on the global oil market.

Indeed, the IEA analysis shows that, given the current inadequate level of investment in conventional oil projects, the market would encounter shortages even without sanctions on a key supplier, such as Saudi Arabia. Any sanctions on Riyadh would undoubtedly exacerbate this situation immeasurably, requiring U.S. shale producers to increase production on a level of a big, not small, miracle.

Thus, in the oil market, geopolitics will continue to rule the day. The current oversupply was initially set in motion by the U.S. geopolitical intervention in the form of the announced tough sanctions on Iran. The impact of this intervention will continue to reverberate through the market.

The decision by OPEC+ in December to cut production will test the political resolve of Riyadh and Moscow to hold ranks for any sustained period of time and allow the market to balance at the cost of the loss of their market share.

Author: Nazrin Mehdiyeva

She is a geopolitics and energy security specialist, working with governments, international institutions and energy majors. She has held senior positions in the private sector and at Oxford University. She is the author of Power Games in the Caucasus and, most recently, co-author of Beyond Blood Oil: Philosophy, Policy and the Future. She is a regular contributor to many prestigious publications.