Oil prices fell below $57 per barrel on January 31 as fears that the coronavirus outbreak in China would slow economic growth and dampen demand in the world’s largest oil importing country. Downward pressure continued on the world’s oil and stock markets as international airlines announced the cancellation of flights to the Chinese mainland, a development that could impact demand for jet fuel and drag oil prices even lower. The market had, however, failed to react to the recent near total collapse of Libyan oil production, the continued absence of Iranian barrels, and smaller disruptions elsewhere. This sanguine response suggests that geopolitical risk is no longer the market force that it had been before the U.S. shale oil deluge.
The price decline to its lowest level in three months signals that markets remain well supplied despite the 1.7 mb/d production cut agreed by OPEC and its non-OPEC allies, the OPEC+ group, in December 2019. Indeed, OPEC is now signaling that it may either extend the agreement beyond March or make an even steeper reduction should the coronavirus outbreak in China affect economic growth and oil demand.
Oil analysts are trying to calculate the possible impact on demand, relying for guidance on the precedent of the 2002-03 Severe Acute Respiratory Syndrome, or SARS, outbreak. In May 2003, the International Energy Agency lowered its oil demand growth forecast for the year by 90,000 b/d because of the SARS epidemic, which had spread to more than 25 countries. However, its impact was temporary, and markets rebounded. In fact, a year later, the Chinese economy registered double digit growth and with that came an increasing appetite for oil, much of which it imports from the Middle East. Although Chinese economic growth has slowed significantly in recent years, it is today the largest importer of crude oil, having overtaken the United States in the last decade, and the second largest energy consumer after the United States. That is why China matters and markets watch Chinese economic data carefully for direction, not only for oil but metals and other goods and commodities. According to the IEA’s December 2019 Oil Market Report, China accounted for nearly three-quarters of the total global oil demand growth of 900,000 b/d in the third quarter of 2019.
It is difficult to predict how long the effects of the latest outbreak will linger and whether the downward pressure on oil prices will continue. Jet fuel is only a small component of a crude barrel when refined. But China is one of the biggest markets for oil producers in the Middle East, particularly Saudi Arabia and Iraq, and they will be the most affected by any slowdown in demand.
Continued instability in Iraq has also threatened to impact markets. First, the U.S. killing of Iran’s Islamic Revolutionary Guard Corps Quds Force commander, Major General Qassim Suleimani, in Iraq exacerbated sectarian divisions and there has been no progress in naming a prime minister acceptable to all factions. An analysis by the Oxford Institute for Energy Studies published in January refers to the “Soleimani effect” and asks if it is a “game-changer for Iraqi crude oil dynamics” due to growing tensions between Baghdad and Washington and a vote by Iraq’s Parliament’s to expel U.S. forces from the country. President Donald J. Trump responded by threatening to impose sanctions against Iraq, which, if applied, would have a devastating effect on the Iraqi economy. Iraq imports natural gas from Iran to supply its power stations and has been granted a sanctions waiver by Washington to do so. However, the waiver expires in March and it is not yet clear if it will be extended by another six months. Iraq is not able to utilize all the gas it produces due to a lack of infrastructure to gather gas, treat it, and process it for use in electricity generation. It therefore relies on Iranian gas to fill the gap to meet domestic demand. Should Iraq lose access to this supply, it would be unable to run its power stations at full capacity, which would lead to interruptions in the supply of electricity and stoke anger on the street.
According to the IEA’s January Oil Market Report, oil supplies from Iraq are potentially vulnerable because of rising political risks. While there has been no significant impact on Iraq’s oil operations since the killing of Suleimani, Exxon and some other foreign oil companies that operate Iraq’s giant oil fields in the south have evacuated staff but oil production has not been curtailed. In recent months there has been a series of anti-government protests in Iraq by a population angry over the lack of public services, corruption, unemployment, and political inertia. One of the protests targeted the Nasiriyah oil field, which shut down on January 20 before production of 82,000 b/d was restored a week later.
Continued tensions do not bode well for further growth in Iraq’s oil production capacity if the uncertainty affects plans to invest in new infrastructure, including the Common Seawater Supply Project led by Exxon. The multibillion-dollar project to inject treated seawater into oil reservoirs to boost secondary recovery is crucial given that Iraq is expected to be the largest contributor in OPEC to supply growth in the future. According to the IEA’s January Oil Market Report, “recent events have shown that Iraq is a potentially vulnerable supplier, just as its strategic importance has grown.” It noted that Iraqi exports had risen from 2 mb/d in 2010 to 4 mb/d currently, adding that this addition was “very welcome as sanctions have reduced Iran’s exports to only 0.3 mb/d and Venezuela’s production has collapsed.” Iran had been exporting in excess of 2 mb/d before the United States imposed new sanctions in May 2018.
The IEA report was published before the extent of disruption to Libyan supply was known. Libya’s oil production has all but ground to a halt in the past week due to a blockade of its main oil ports in the east by forces loyal to General Khalifa Hifter, who has launched an offensive to capture Tripoli and topple the U.N.-recognized government in Tripoli.
Mustafa Sanalla, chairman of the Libyan National Oil Company, said in London on January 28 that he expected oil production to fall to 72,000 b/d within days from 262,000 b/d currently because of the blockade. All fields were being shut down and only two offshore fields would continue to operate in coming days, he said. Libya had been producing around 1.3 mb/d, which is slightly below capacity, before Muammar al-Qaddafi’s downfall in 2011. With no peace deal in sight, there is no telling how long Libyan oil will be offline or whether the market can afford a further supply shock. Sanalla said the recent stoppages meant that chances of raising production capacity to 1.5 mb/d in the near term and a longer-term target of 2.5 mb/d “may have been lost.”
For now, geopolitical risk appears to have been superseded by concern over demand growth, which explains why oil prices have remained virtually static despite a significant dent to global supplies.
According to the IEA’s January report, recent tensions in the Middle East added another layer of uncertainty to the oil market outlook. “We do not know how the geopolitical situation will play out over time, but for now the risk of a major threat to oil supplies appears to have receded,” the report indicated. The IEA expects non-OPEC production to rise by 2.1 mb/d, led by the United States, despite an expected slowdown in U.S. shale production growth. New supply is expected from Norway and Brazil as well as Guyana, which joined the club of oil exporting countries in January. Much of the increase will occur in the first half of the year. The OPEC+ ministers will have to take all these developments into consideration when they meet again in March.
That the oil market responded to demand side concerns points to a structural change that has been largely due to the growth in U.S. light tight oil, or shale oil, a development that has disrupted the natural order of the past when OPEC exerted more control and could sway markets one way or another through supply management. Forced to cede market share to the United States, OPEC’s de-facto leader Saudi Arabia sought out fellow energy giant Russia to form a wider alliance of oil producers eager to restore some balance to the market. By restricting supplies through a series of production cuts starting in 2016 with the first Declaration of Cooperation between OPEC and non-OPEC producers, the hope was that markets would tighten enough to lift prices to levels that would sustain their economies. However, having abandoned the previous policy of defending market share, OPEC and its Russian-led partners have found that they need to stick with the policy of production restraint because the resilience of U.S. shale oil producers regardless of price levels has left them with few other options. Prices remain stuck in a range closer to $60 than $70 and the market remains well supplied despite a succession of outages.
This is the dilemma that members of the expanded OPEC alliance have been facing. But they have little to show for their efforts, except perhaps putting a floor under prices. However, prices would be far lower were it not for the fact that a significant volume of oil has been taken out of the market by the OPEC+ cuts and unrelated disruptions.
