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Opinion

Middle East turmoil hands another victory to US oil producers

Kurdistan conflict could mar Iraq's reputation as a stable crude supplier

The oil fields of Kirkuk have been at the center of conflict in northern Iraq.   © Reuters

A surge in U.S. output holding down crude prices while OPEC restrains its own supply is not the only worry for the producers' group in its ongoing war with the shale sector. The increasing frequency of outages and threats to production due to regional and national geopolitical strife across the Middle Eastern and North African producer countries is chipping away at OPEC's credibility as a reliable supplier of crude to the world.

The "fear premium" injected into crude by a disruption or perceived threat to supply may occasionally benefit certain participants in the oil supply chain and speculative traders of oil futures who profit from price volatility. However, for crude buyers, it means rejigging procurement plans at the last minute and putting up with higher feedstock costs for weeks or even months.

A case in point is the recent flare-up of tensions in OPEC's second-largest producer. In Iraq, violence erupted between the federal government in Baghdad and the semi-autonomous region of Kurdistan in the north of the country, which voted for independence in a referendum on Sept. 25.

The armed forces of the federal government seized control of major oil fields in the disputed Kirkuk province from the Kurds on Oct. 16 but landed in a stalemate as the only pipeline evacuating the crude from those fields, which is shipped to overseas buyers from the Turkish Mediterranean port of Ceyhan, is controlled by the Kurds. As a result, oil supply from northern Iraq has fallen to less than half the normal average of 550-600,000 b/d in recent days, and crude prices have spiked. As the conflict in Iraq simmers, the oil market will need to continue assessing and pricing in the risk to Kurdish oil flows from a growing armed conflict or a protracted civil war.

For regular buyers of Iraqi crude, it represents a double whammy of higher benchmark Brent and Dubai crude prices on account of the fear premium inflating their overall import costs as well as the risk, albeit a small one at this stage, that a force majeure resulting from a major production outage might upset their procurement plans.

Supply disruptions due to geopolitical problems are especially a pain-point for Asian countries with rising oil products consumption and growing dependency on crude imports. The bulk of their purchases are through evergreen contracts with Middle Eastern producers that are renewed on an annual basis, a system in place for decades and originally meant to provide the buyers security of supply.

That surety has been especially critical because a majority of Asian countries have not had strategic petroleum reserves to cushion them in the event of emergencies. China, the world's largest crude importer and second-largest oil consumer after the U.S., began setting up its SPR in 2007 and, despite an aggressive construction and filling-up schedule, is yet to reach its target of 511 million barrels in strategic storage. Even that volume would be only around 70% of the International Energy Agency's mandated 90 days equivalent of net crude imports that the OECD countries have to maintain as emergency stockpiles.

India, the second-largest oil consumer in Asia, has been even slower, having set up capacity for about 39 million barrels of strategic crude reserves, equivalent to only about nine days of its imports, in recent years.

When OPEC decided in November 2016 to reduce its collective output by about 1.2 million barrels per day, its crude buyers knew they would get a percentage cut in their monthly lifting volumes under their annual contracts, a gap they would need to fill by buying in the "spot market," which involves transacting deals for one cargo at a time. Such spot cargoes typically come from non-OPEC producers, thus eating into OPEC's market share for as long as the organization maintains its output cuts.  

When unforeseen geopolitical events in producer countries reduce crude supplies, their buyers have to ratchet up such spot purchases, sometimes at short notice. That requires a degree of trading and hedging savvy and dexterity to maintain profit margins, which can be a challenge for refiners in Asia, typically national or state-owned oil companies that may be heavily bureaucratic and more encumbered by government regulations than their private sector counterparts.

Crude from countries plagued by constant supply disruptions, such as Libya, Nigeria, Syria or Yemen in recent years, is often sold at a discount to what would have been its fair value to compensate buyers for taking the risk of unpredictable loading schedules. Big oil traders or international oil majors with a large web of supply sources may be able to take the risk more easily than NOCs and SOEs in Asia, whose overriding mandate is to maintain adequate supply of refined products to the domestic markets.

Iraq has gradually managed to reconstruct its oil infrastructure and nearly double its oil production to 4.4 million barrels per day in the post-Saddam Hussein era. Most of the crude exports are through the country's south, which are known to be reliable and stable. Should the latest Kurdish conflict spread across the country and disrupt those flows, Iraq would lose its reputation as a dependable supplier.

Even if that worst-case scenario does not come to pass, the latest tension adds to the overall picture of increasing geopolitical problems becoming a constant threat to oil supplies from the Middle East -- whether due to age-old sectarian rifts between Shiites, Sunnis and other minorities; the presence of the Islamic State group in Iraq and Syria; proxy wars such as the one in Yemen and the Arab embargo against Qatar; protracted civil wars such as the one in Syria; or the latest threat from the U.S. to the international nuclear deal with Iran. The list goes on.

The U.S., with its rising crude production and exports that have been climbing to new historic highs above 1 million barrels per day in recent months, has stepped right into the breach left by OPEC. The country exported around 914,000 barrels per day of crude on average over the January-July period this year, compared with 591,000 barrels per day through 2016. U.S. benchmark WTI's widening discount to Brent and Dubai has incentivized buyers in Asia, who see a bargain even after paying higher freight costs compared with shipments from the Middle East.

China has risen to become the second-largest buyer of U.S. crude this year -- behind Canada. Japan, Singapore, South Korea and Malaysia have become other regular buyers. India last month not only joined the club, but jumped in headlong, with nearly all its state-owned refiners as well as the largest private sector refiner Reliance Industries Ltd. receiving or placing orders for their maiden U.S. crude cargoes.

It may be opportunistic buying by Asian refiners for now, supported by the deeply discounted WTI, but as time passes, U.S. crude has the potential to get entrenched in their diet not only because of its increasing availability, but importantly, as a welcome supply source free of geopolitical threats. That would be a tough one for OPEC to beat.

 

Vandana Hari is founder of Vanda Insights, which tracks energy markets. She has two decades of experience providing essential intelligence on the energy commodities sector

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