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OPEC+ faces difficult decisions as Covid returns, recession risks rise, and oil prices crash

Oil markets
By Paul Hodges on 28-Nov-2021

OPEC+ oil producers saw prices tumble $10/bbl (13%) on Friday as the world woke up to the fact that the next phase of the pandemic may be underway. And this is not the only challenge that they face.

The first is the challenge from the oil markets, as the head of the International Energy Agency (IEA), Fatih Birol, spelt out last week:

“Some of the key strains in today’s markets may be considered artificial tightness… because in oil markets today we see close to 6mb/d of spare production capacity with the key producers, OPEC+ countries.”

OPEC seems to have gone back to the failed policies of the early 1980s. Then they cut back volume during the recession in order to maintain high prices. This, of course, made the recession even worse, creating a vicious circle – as veteran Saudi Oil Minister, Ali Naimi, described back in 2015:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.

Unfortunately, of course, this essential lesson keeps being forgotten. The same mistake was made ahead of 2014 and then again last year. Both times, prices collapsed after a period of artificial shortage. And now, as Birol says, the same mistake is being repeated.

The problem, as the chart shows, is that high oil prices lead to recession. And recession automatically reduces demand for oil – hence the vicious circle. The key moment in when the cost of oil reaches ~3% of global GDP:

  • People still have to travel for work, act as a taxi service for the kids, and heat/cool their homes
  • They therefore have to cut back on discretionary spending – which drives GDP growth

There was only one occasion in the last 50 years when this logic did not hold true, in the period to 2014. The massive $25tn+ central bank stimulus programmes avoided a recession.  But it didn’t help OPEC, as the oil price still crashed from $115/bbl in June 2014 to $28/bbl in June 2015.

There is even less logic today for holding prices artificially high.  COP26 earlier this month confirmed that the world is moving towards Net Zero. It has therefore agreed to phase out the use of fossil fuels in order to reduce CO2 emissions:

  • Today’s high prices actually support the move to renewables, as these become cheaper on a relative basis.
  • They also upset consumers and legislators, who don’t like being held to ransom in the middle of a pandemic.

And as the IEA warned in 2014:

“In oil-importing countries, price effects are asymmetrical: Demand lost to substitution or efficiency gains during prolonged periods of high prices will not come back in a selloff.”

Refiners are already reacting to this logic, as we noted in this month’s pH Report, with Shell closing crude oil refining at the Rhineland Refinery in Germany. They plan to convert it into a “venture focused on renewable energy-derived hydrogen, sustainable aviation fuels and renewable liquefied biogas.”

OPEC+ oil producers therefore have a clear choice ahead of them.  They either accept the logic of Net Zero and focus on building alternative income streams to replace their fossil fuel exports. Or they try to fight this logic and keep prices high – and instead end up accelerating the move away from fossil fuels.