Oil prices ended last week in freefall as the world’s largest group of producers from petro-states in the Middle East dithered over whether to cut output
By Andrew Critchlow, Commodities Editor
A secretive group of the world’s most powerful oil ministers will soon gather in Vienna to take arguably one of the most important decisions that could affect the still fragile world economy: whether to cut production of crude to defend prices at $100 per barrel, or keep open the spigots as winter looms among the biggest energy-consuming nations?
A sudden slump in the price of crude has exposed deep divisions within the Organisation of Petroleum Exporting Countries (Opec) ahead of its final scheduled meeting of the year next month to decide on how much oil to pump.
Some members, led by Iran, have called for immediate action to stem the drop in oil prices, while the Arab sheikhdoms of the Gulf have so far argued that it could be another three months before it becomes clear whether the group should cut production for the first time since December 2008.
Whatever they decide, oil remains the lifeblood of the global economic system due to its direct impact on inflation and input prices. Brent crude – a global benchmark of oil drawn from 15 fields in the North Sea, dipped last week to multi-year lows below $92 per barrel as a perfect storm of a strong US dollar, oversupply in the system and declining demand shattered confidence in the market. Brent has tumbled 20pc in the last three months after touching $115 per barrel in June.
In the US – the world’s biggest consumer – crude for November delivery at one point last week dropped below the psychologically important $90 pricing level, raising fears that a prolonged slump could put many of America’s shale drillers out of business. Shale oil, which can cost up to $80 per barrel to produce, has spurred an energy revolution in the US, which has started to threaten the dominance of producers in the Middle East.
However, at current price levels many of these new so called “tight oil” wells are approaching the point when they will soon become unprofitable.
Like the situation in the US, falling oil prices are also a double-edged sword for Britain’s economy and investors. Although George Osborne, the Chancellor, is less reliant on tax revenues from the North Sea than some of his predecessors, prices are approaching the point when many of the developments planned offshore west of Shetland by international oil companies could be placed on ice.
A sharp drop-off in domestic oil production and associated tax receipts from the North Sea would give Mr Osborne an unwelcome hole to fill in the government’s public finances heading into next year’s general election. However, falling oil prices will help to keep inflation low.
For Britain’s motorists the current declines have been good news that has trickled through to the price of petrol on forecourts. A litre of unleaded petrol in the UK has fallen a few pence over the past month to an average of around 127.21p on average, a figure last seen in 2011, just before Mr Osborne raised the value added tax on fuel to 20pc, from 17.5pc.
All eyes are now firmly focused on the next move by Opec, which controls 60pc of the world’s oil reserves and about a third of daily physical supply. The group has been branded an unaccountable “cartel” by free-market critics in North America who claim its system of limiting production by setting an output ceiling and quotas is tantamount to price rigging.
Although this is an accusation that the group’s secretariat which is based in Vienna strongly denies, its mostly unelected group of policymaking oil ministers undeniably pull the strings of the global energy industry in the same way that central bankers can control currencies.
Opec states have largely managed to maintain cohesion over the last decade as prices over $100 per barrel have enriched their economies and encouraged adherence to quotas. This consensus is now starting to break down, creating more uncertainty in the market and a potentially destabilising situation for the global economy.
Next month’s meeting promises to be the most tense held since the onset of the Arab Spring in 2010, with the Shi’ite Muslim faction of Iran and Iraq already appearing to line up against Saudi Arabia and the United Arab Emirates (UAE).
Iran’s Oil Minister Bijan Zanganeh has placed his cards on the table early by calling for Opec to urgently cut output to stem the sharp recent decline in prices, which threatens the Islamic Republic’s fragile economy after years of restrictive sanctions.
According to research from Deutsche Bank, Iran has the highest fiscal break-even price for its budget at over $130 per barrel of Brent, compared with the UAE at around $70 per barrel and Saudi Arabia at about $90.
However, the Gulf’s Arab states are all sitting on huge cash piles that are held overseas through sovereign wealth funds and foreign currency assets that can be drawn upon to help them weather any short-term drop in oil export revenues.
Iran, possibly supported by Iraq, will push hard for a change in Opec’s production targets at the meeting and a cut to its overall output by 500,000 barrels per day (bpd) from the 30m bpd limit that it currently sets for members. The latest figures suggest that level has already been breached with Opec members perhaps pumping as much as 1m bpd above the group’s agreed quota.
“Considering the downward trend in prices, Opec members should try to temper production to avoid further price instability,” Mr Zanganeh was quoted saying by Iranian state media at the end of last month, even before crude fell to its current lows.
Mr Zanganeh is at odds with his most powerful rival in Opec, Saudi Arabia’s influential oil minister, Ali Naimi, who has so far dismissed calls for an emergency meeting to be held ahead of November. Nevertheless, the kingdom has taken the precaution of trimming its own output and reducing the price of crude it offers to customers in Asia in an apparent move to defend its market share.
According to Opec figures, Saudi Arabia cut its output over the summer by more than 400,000 bpd to 9.6m bpd. Although the kingdom’s dominant role in global oil markets is increasingly being challenged by the rise of US shale, Saudi retains its place as the swing producer due to the almost 3m bpd of physical capacity it currently holds in reserve.
Demand for crude normally spikes during the northern hemisphere’s winter season and some Opec officials have argued that the group should wait to see if there is a repeat of the “polar vortex” conditions that shut down the eastern seaboard of the US and led to a brief contraction in the country’s economy in the first quarter.
“Winter is coming,” a senior Opec delegate from the Arab side of the Gulf recently pointed out to The Sunday Telegraph when asked about the meeting. “This softness in the market is not long enough to be called a correction so let’s wait until we’re sure it is a correction before taking any action.”
“Within Opec we are not concerned about the price; what concerns us is that the market is well supplied,” he said.
Saudi enjoys some of the lowest production costs, excluding capital expenditure on new projects, in the region of $2 per barrel, giving it a large margin to soak up a sudden drop-off in price. This compares with estimated production costs in the North Sea which are in the region of $50 per barrel, according to Oil & Gas UK figures. This leaves drillers offshore in Britain more susceptible to price fluctuations.
To further complicate the forthcoming meeting, Arab Gulf states remain deeply suspicious of Iran as the leadership in Tehran edges towards a settlement with Western powers over its nuclear programme. An end to Tehran’s economic isolation could trigger the opening up of its oil industry to foreign investment, a move that would bring more crude onto an already flooded market.
Iran is currently producing around 3m bpd of crude but it is thought with access to Western technology this figure could be easily doubled. Combined with Iraq, which aims to eventually increase production capacity to as much as 9m bpd by the end of the decade, both countries could challenge the current dominant position of Saudi Arabia and the Arab Gulf states within Opec.
The looming issue of global over-capacity has been further complicated by the sudden return to the market of light, sweet Libyan crude. Exports from Es Sider have returned to levels of around 800,000 bpd over the last month, adding to the pressure on Brent. In the background is the surge in US shale oil production and the mounting pressure on President Barack Obama to lift the US crude export ban that has been in place since the 1970s to guarantee America’s energy security.
Fracking has helped the US achieve its highest oil production levels since 1986 over the last two months at a rate of 8.5m bpd. The threat of a full lifting of the ban on exports has also helped the US to drive down the price and potentially cripple the Russian economy. Moscow is largely dependent on crude sales for foreign currency earnings and oil trading at around $80 per barrel for a period of months could bring the country to its knees.
Indeed, losing market share to shale drillers in the US and the potential growth of unconventional oil and gas in other regions is a risk that traditional Opec producers are increasingly having to confront. Recent data from the US Department of Energy has revealed that Nigeria, also a member of Opec, has dropped out of the list of countries supplying America with oil.
According to Deutsche Bank analysis “tight oil” in North America would be unlikely to attract investment at a cost of $90 per barrel, close to its current levels. Certain members of Opec are also keen to see countries like the US take more responsibility for maintaining price stability instead of solely focusing on increasing production.
The German investment bank estimates that if Opec fails to cut production in response to the current trend in falling oil prices then around 9pc of US “tight oil” output would be immediately rendered uneconomic at a level of $90 per barrel. This figure would rise to 39pc should prices slump as low as $80 per barrel.
However, some officials within the group already believe that the US should itself shoulder some of the burden.
“The culture of blaming Opec needs to change,” said the Opec delegate. “The responsibility for the market has to be shared.”
On the demand side, a number of leading energy think tanks have recently revised their estimates for demand based on the unexpected slowdown of the Chinese economy in the second half of the year. These worries escalated in August with the latest data showing a slowdown in industrial production in the world’s second-largest economy.
China has picked up much of the slack as the US has moved over the last five years to reduce its dependence on Middle East oil and a longer term slowdown could trigger Opec nations to slash output aggressively to defend prices.
Beijing is now viewed by many Gulf oil producers as a more important energy trading partner than the US, which has been the traditional focus since the end of the Second World War.
The International Energy Agency – the world’s top oil watchdog – revised down in September its forecast for demand for both 2014 and 2015 in response to China’s sudden slowing. The Paris-based group cut 900,000 bpd from demand growth this year and 1.2m bpd from its forecast in 2015, when it expects the total global draw on oil to be in the region of 93.8m bpd.
To complicate the decision that Opec oil ministers face in November, the region is now confronted by the sinister rise of the Islamic State jihadists in northern Iraq and a bitter row between some of its Arab Gulf members over the support of extremists. In Iraq and Syria, the group known as Isil, is itself thought to be profiting from the sale of oil to the tune of $2m a day.
Given that Gulf states have pulled in the major powers led by the US and the UK into taking military action against Isil they may feel obliged to keep pumping at current rates, at least while Western forces carry out strikes and destroy the biggest single threat to their own borders.
“Nothing has changed on the international stage since our last meeting,” said the Opec delegate, adding. “Arguably, it has just got worse.”