December 1, 2013 4:37 pm

Oil supply: The cartel’s challenge

Shale gas and eased sanctions on Iran will test Opec’s ability to curb output and buoy prices
Gas flare in the countryside of Bradford County. Pennsylvania©Corbis

The US is producing more crude oil than it imports and in a few years is expected to become the world’s largest oil producer

At a private dinner early in November a group of executives from one of the world’s largest commodity traders was asked to predict the price of oil in a year’s time. Without exception the forecasts, scribbled on place cards without consultation, were for Brent crude to fall well below the $100 a barrel level it has traded above for most of the past three years.

Those predictions reflect a growing consensus in the oil market. From US shale to an easing of sanctions on Iran, the coming years are expected to provide a huge boost to global output, inverting the structure of the oil market in which supplies have long been rationed by a handful of producers.

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That is a concern for the Opec group of oil producers as its ministers prepare to meet in Vienna this week. The cartel of Middle Eastern, Latin American and African producers has had a strong run as prices have stayed high, allowing some members to pump as much oil as they can.

But many forecasters expect Opec to cut its production next year as supply rises from the US, Canada, Kazakhstan and other countries outside the cartel.

“Opec is still crucial to the market because of its ability to curtail production. The question is whether any member apart from Saudi Arabia is prepared to do that in the future in response to changing market conditions,” says Jason Bordoff, director of the Columbia University Center on Global Energy Policy, until recently an Obama administration official.

Talk of an oil supply revolution begins in the US. America is producing more crude than it is importing for the first time since the 1990s. Within a few years it is expected to be the world’s largest oil producer.

The country may also be weaning itself off its addiction to oil. This year consumption of petroleum products is running 10 per cent below its 2005 peak, while cheap and abundant shale gas is finding its way into train and truck engines, making inroads into oil’s monopoly as a transport fuel.

So far this has had little impact on oil prices, as civil war in Libya and sanctions against Iran have offset US production growth. Brent has averaged around $108.50 a barrel this year and Saudi Arabia has had to produce at record levels of more than 10m barrels per day. Output from other Gulf states, Kuwait and the United Arab Emirates, is also close to, or at, record levels.

US imports from the Middle East have held up remarkably well, too, as sophisticated Texan refineries continue to rely on the region’s heavier crudes. But the US transformation has not gone unnoticed in the Gulf, particularly in Riyadh.

“The US is saying it will be the largest producer in the world, that it will become energy independent and that the world will depend less on imported oil. All of these messages are disturbing,” says Mohammad Al Sabban, a senior adviser to the Saudi oil minister from 1986 until last year.

Saudi observers are not worried so much by growing US production as by what they perceive to be a change in strategy by their oldest ally.

The deal with Iran on its nuclear programme last week and the US retreat from air strikes against Syria make Sunni Gulf monarchies nervous that the US is cosying up to their Shia rivals in the region. Industry officials past and present in the country are drawing a direct link between American foreign policy and the oil market.

“There is a clear perception that there is a lack of strategy and lack of thinking in major countries in the west, in particular the US,” says Sadad Al-Husseini, the former head of exploration at Aramco, the Saudi state oil company, who now runs a consultancy.

“They don’t appear to know what they want to do in foreign policy, or in economic policy, and that creates uncertainty for oil producers.”

Uncertainty about demand is reflected in investment decisions. Earlier this year Saudi Arabia said it no longer planned to increase oil capacity beyond its current level of around 12.5m b/d before 2040 because of the growth in supplies elsewhere.

The UAE has reportedly pushed back its target for increasing production capacity to 3.5m b/d from 2017 to 2020. In Kuwait the government is struggling against parliament to justify further investment in spare capacity.

Gulf states are certainly still spending – Saudi Arabia ploughed $17bn into developing the Manifa field, which started production this year. Output there is expected to reach 900,000 b/d, equal to current production in the Bakken or Eagle Ford shale formations, the leaders of the US shale revolution.

But investment is increasingly aimed at replacing declining production from mature fields, rather than increasing capacity.

“The cost of investing in spare capacity is very high, and I tell you there is huge pressure from the populations of the Gulf to allocate investment to something else,” says Mr Al Sabban.

But Gulf officials scoff at the idea that a growing diversity of supply poses a wider threat to demand for their crude.

Surging US oil production has obscured disappointing output in a number of other countries outside Opec, which were expected to emerge as counterweights to the cartel.

In Brazil, ultra-deepwater discoveries in 2007 and 2008 were meant to propel the country into the top ranks of oil producers. Instead output declined in 2012 and the International Energy Agency expects it to fall again this year as Petrobras, the state oil company, struggles to extract oil from beneath 4km of water, rock and salt.

In Kazakhstan the enormous Kashagan oilfield continues to bamboozle the combined talents of ExxonMobil, ENI, Royal Dutch Shell and Total with its leaks of deadly hydrogen sulphide gas and ice packs. After a decade of delays and $50bn of investment, production finally began in September only to be halted within weeks by another technical fault.

. . .

In each of the past three years the IEA, which formulates energy policy for industrialised countries, has underestimated demand for Opec crude at the start of the year. Now it is tempering its optimism on non-Opec supply growth.

At the release of its annual report on global energy markets last month, the Paris-based organisation characterised shale as merely a brief interregnum within the otherwise steady control of Opec over the oil market.

“I am really worried that we are giving the wrong signals to the Middle East, which may end up with us not having investment in a timely manner,” said Fatih Birol, the IEA’s chief economist. “The wait and see behaviour is definitely not in the interest of consumers or global oil markets because it may mean significantly higher prices in the future.”

The IEA expects US production of light, tight oil – the IEA’s term for shale oil – to peak in 2020 and decline thereafter. Outside the US, the IEA expects light tight oil production to contribute only 1.5m b/d of supplies by 2035 as countries such as Russia and China make limited progress toward unlocking their shale reserves.

Then there is cost of production. Even when it is produced on time and on budget, unconventional oil is expensive. The IEA estimates the cost of ultra-deepwater production at up to $100 a barrel compared with a maximum of just over $20 a barrel for conventional output in the Middle East. That means if oil does fall below $100 for a prolonged period, high-cost production from Canada’s oil sands to US shale fields might have to be halted, allowing prices to recover.

Perhaps the greatest threat to Opec – apart from an emerging markets crisis or a sharp slowdown in Chinese economic growth – comes from with­in: the potential for much cheaper oil to be produced by its own members.

A comprehensive deal on the Iranian nuclear programme could see Tehran increase production by 1m b/d within months. Iraq aims to increase production by about 500,000 b/d next year to 3.5m b/d as it continues to rebuild its oil industry following the US-led invasion.

Long shut out of the market by sanctions and war, Iran and Iraq are unlikely to heed the cartel’s production target of 30m b/d as they seek to regain market share.

Ed Morse, a veteran analyst at Citi, argues Opec will be forced to confront increasing production from within its ranks next year as growing US output erodes demand for Opec crude. He also thinks most forecasters are underestimating the potential for the US shale boom to be replicated in other countries, posing further long-term challenges to the cartel.

Others go further. “The time for Opec has passed,” says Fereidun Fesharaki, chairman of Facts Global Energy, a consultancy. “We are entering a new world with plenty of hydrocarbons and a diversity of supply. The direction is clear, it is just a matter of time.”

. . .

As prices have held steady above $100 a barrel, Opec has allowed its organisational structure to atrophy, raising questions over whether it can now impose discipline if required.

Opec stopped publishing individual country quotas five years ago. Since 2011 Saudi Arabia has largely ignored the group production target, instead tailoring output to customer demand. Every other member pumps as much oil as it can to take advantage of high prices.

“If Opec falls apart, it will be because the organisation lacks the ability to resist internal production growth, rather than US shale,” says Amrita Sen, head of the Energy Aspects consultancy.

As a rule Opec prefers to wait for shifts in supply or demand to filter through to oil prices before acting to raise or curb output.

The organisation is highly unlikely to confront production growth head on at this week’s meeting either. Iran and Iraq may create headlines with promises to step up production and insinuations of a price war with Saudi Arabia for market share.

But Ali Naimi, the Saudi oil minister, and Abdalla El-Badri, the Opec secretary-general, are likely to shrug their shoulders and counsel patience.

Should the anticipated supply surge materialise, the resulting fall in price would also increase the incentive for members to agree on production cuts.

During the financial crisis in 2008 Opec agreed to across-the-board cuts as Brent prices dropped by 75 per cent. The Asian financial crisis of the late 1990s provides a less promising precedent. Opec did eventually cut production but only after Brent fell to $9 a barrel, a fate today’s members would not want to repeat.

“Opec has historically always been more effective when prices are heading down than when they’re heading up,” says Bill Farren-Price, a long-time observer of the organisation at Petroleum Policy Intelligence. “I have no reason to believe that they would not be able to cut a deal this time.”

If the traders’ dinner predictions turn out to be correct, we will soon find out.

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Iraq: Conflict clouds the next decade of production

For the next decade in oil markets, much will depend on Iraq, writes Ajay Makan.

War and sanctions limited production from 1990 to 2008, leaving Iraq with plentiful reserves that are relatively cheap to exploit. Iraq has overtaken Iran as the second-largest Opec producer. The IEA expects output to double to 6m barrels a day by 2020.

But this year has been the bloodiest since 2008. Violence is spreading to the Shia-dominated south, Iraq’s main oil-producing region. Jitters swept the industry last month when Baker Hughes, a US oilfield services group, suspended operations and Shia protesters, angered by a religious slight, attacked a staff camp at Schlumberger, also a services provider.

Traders are beginning to scale back expectations for the country. “The industry almost accepts as a given that there will be security problems on an ongoing basis and that is a concern,” says David Fyfe, head of analysis at Gunvor, a commodity trader. “Instead of half a million barrels a day of extra exports, we might see only a fraction of that.”

A senior trader at a large energy company is even more downbeat: “It will be a challenge to avoid a major disruption to the industry. Export growth is not guaranteed.”

Apart from security problems, international oil companies say crumbling infrastructure is making it impossible for them to raise production to levels agreed with the government.

Iraq’s principal export terminal near Basra is vulnerable to disruption. In November exports were halted when bad weather prevented ships loading. That meant the Rumaila oilfield, Iraq’s largest with more than 1.3m b/d of production, had to be shut down for a few days, according to industry sources. “As soon as there is any problem further down the chain, you have to shut in production at a field and it takes weeks to restart because the equipment is old and rickety,” complains one oil company.

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