Market dictates the price of oil from now on

Just four weeks ago, a drone attack was launched against the key Saudi oil facilities at Abqaiq on the Gulf coast. The attack was widely but inconclusively blamed on Iran or its allies, the Houthi rebels in Yemen. Several plants were damaged, taking some 5m barrels a day of oil supply off the world market. As Financial Times reports, instead of soaring, the oil price has fallen below where it was before the attack and is at risk of falling further. After decades in which the Opec cartel has controlled prices, the market now dictates the value of a barrel of oil.

The Abqaiq attack is not the only disruption to supply. President Nicolás Maduro remains in power in Venezuela, which has the world’s biggest oil reserves but is seeing a continued fall in production as a result of its chaotic situation, particularly in the state-owned oil company PDVSA. In September, output was 644,000 barrels a day, 1.3m b/d less than two years ago

Iran exports are down — more than 2m b/d below where they were in April 2018 just before the current round of US sanctions began. Libyan exports have also been hit for several years by the conflict between the country’s different factions.

In addition, there is a production quota system in place to constrain output involving not just the members of Opec but a wider group of producers including Russia, Mexico and Kazakhstan. Overall, the regime has been honoured by most of the signatories.

But, despite all this, the message of the past four weeks has been loud and clear: there is no shortage of oil. Each time supplies are reduced by one problem or another, alternatives become available.

After the attack on Abqaiq, even speculators stayed away from the trading market. Hedge funds that might have been expected to buy oil and push prices up towards $100 a barrel have been burnt once too often.

The events around Abqaiq not only confirmed the immediate strength of supply but also highlighted the fact that the circumstances that could lead to a sustained price surge are very unlikely to happen. The attack did not trigger a war between Iran and Saudi Arabia that could have closed the Strait of Hormuz, the world’s largest single oil transport route. The flow of tankers that carry more than 20m b/d of Middle Eastern crude, mainly to customers in Asia, has been unaffected.

Neither the leaders of the Islamic Republic of Iran nor Saudi Arabia’s monarchy can risk starting a full-scale conflict. Nor does the US, for all President Donald Trump’s anti-Iranian rhetoric, want to get involved in another war in the Middle East a year before presidential elections.

The result is that, after a brief spike in the days after Abqaiq, oil prices have fallen back below $60 a barrel for Brent crude and below $55 for WTI, the US benchmark.

Abqaiq could be fully back on stream in a matter of weeks, and with the market oversupplied already, the full resumption of Saudi exports will pose a huge challenge for Opec. To achieve $70 a barrel — the target of most Opec members — will require a further global production cut of at least another 1m to 2m b/d, even if output from Iran and Venezuela production remains severely constrained.

It is hard to see where such a reduction could come from. When prices are low, the temptation is to increase production in search of revenues, rather than reduce. With renewed plans to sell a stake in Saudi Aramco, the Saudis will be hard pressed to convince investors that dividends are secure if they are forced into another large scale production cut.

The net result is that we are closer than at any time in the last 50 years to a free open market in oil. The end of the cartel’s control should bring prices down. But for the producing countries, international oil companies and investors, an open market is a recipe for even more volatility and uncertainty. 

The sector may come to look back on Opec’s half century in power as a golden age of stability.