The failure of the Opec+ group to secure a deal on raising oil supplies has propelled crude prices to their highest level in at least three years.
Brent, the international benchmark, reached $77.84 a barrel on Tuesday — the highest point since 2018 — while US benchmark West Texas Intermediate hit $76.98 — the highest since 2014.
Why have Opec+ members fallen out?
The group agrees on the need to raise oil production, as demand has started to outstrip supply. But the United Arab Emirates, one of the most powerful members of the group after Saudi Arabia and Russia, has objected to extending an agreement first forged in April last year — when oil prices were tumbling — unless the group agrees to revisit how the emirates’ production target is calculated.
This might seem a minor objection when the group wants to raise supply anyway, but the UAE has invested billions of dollars in increasing production capacity. It feels the so-called baseline used to calculate its production target is outdated and does not reflect that new capacity, meaning it is cutting proportionally more supply than other members.
The country’s energy minister has said it will stick with its original baseline until April 2022 — the expiry point of last year’s deal — but cannot agree to extend it further without a revision. Saudi Arabia, normally one of its closest allies, wants the agreement extended to the end of next year to give the market greater clarity.
The UAE has a point. But if the group agreed to review one country’s baseline it would feel pressure to do this for every other member of the alliance, and some would not like the result.
Russia, not an Opec member, has been co-operating with the group since 2016. But it is among the countries whose production target may fall under such a review.
Tensions are also growing between Saudi Arabia and the UAE, which increasingly view each other as competitors in the Gulf region.
“The staunchest allies not so long ago, the two Middle Eastern nations now have diverging views on a number of issues: the Yemen war, the relationship with Israel or Qatar and the Saudi intention to compete with the UAE as a regional business and tourist hub,” said Tamas Varga at oil brokerage PVM.
What next for oil prices?
They have already jumped. The group had planned to raise production by 400,000 barrels a day each month until at least the end of this year, adding 2m barrels a day (or roughly 2 per cent of pre-pandemic demand) back to the market, gradually unwinding the huge 10m b/d cuts agreed in the teeth of the pandemic shock last year.
Without an agreement the default option is to leave production unchanged, meaning a tighter oil market in the second half of this year as demand picks up. Many banks are forecasting that prices will comfortably rise above $80 a barrel — up more than 50 per cent since January and above where they traded before the pandemic.
The big risk is that if this disagreement remains unresolved, it will undermine the cohesion of the group and lead producers to start ignoring output targets. In an extreme scenario this could even lead to a price war, such as in March last year when Saudi Arabia opened the taps after disagreeing with Russia over how to respond to the emerging pandemic.
But Saudi Arabia is likely to prefer a higher price. Analysts close to the kingdom say Riyadh wants to incentivise other producers to invest, fearing a supply gap is on the horizon.
Think of it as a Goldilocks strategy. Saudi Arabia wants prices high enough to encourage investment, but not so high that they accelerate the adoption of renewables and the end of the oil age.
Will a higher oil price encourage other producers to raise their output?
Maybe, but not quickly. Oil majors like BP and Royal Dutch Shell are under pressure to scale back oil and gas production and invest more in renewables. Investing in large long-term projects — which may have a lifespan of 50 years — looks less viable when oil demand is expected to peak in the next decade.
But the logjam does raise the risk of demand growing faster than supply before that moment is reached, especially as non-Opec producers are not stepping in to fill the gap. “If this had been any other cycle of the last 50 years, non-Opec producers would be reactivating projects and raising capex guidance by now. Not so on this occasion,” said Martijn Rats, an analyst at Morgan Stanley.
Eventually, further price rises could encourage US shale producers “to come back swinging in 2022”, said Edward Morse at Citi.
What about the wider market?
The return of inflation has been a hot topic in 2021, and a rising oil price feeds into those fears. Gold, traditionally seen as a hedge against inflation, rose 1 per cent on Tuesday to $1,805.71 an ounce.
As well as placing a strain on consumers, a rising oil price could further “derail the [US Federal Reserve’s] narrative that most of the current spike in inflation should be seen as transitory”, said Jeroen Blokland, an analyst previously at asset manager Robeco. But he cautioned that Opec+ was probably aware of the risks of seeing prices rise too far, unnerving markets.