From the Editor: What OPEC’s output cuts means for LNG [Gas in Transition]

Could OPEC’s market grip strengthen as the sun fades on oil consumption?

It is easy to assume that as the energy transition takes hold, oil consumption will fall, undermining the role played by OPEC and its bigger, scarier brother OPEC+. Control of a declining market will become increasingly difficult as demand destruction gathers pace.

Maybe. But this is not the scenario which appears to be emerging.

Cartel control is growing. Not only that, but despite the energy transition, and an imminently expected recession, the oil market has yet to peak, and may not do so until the mid-to-late 2030s, owing to rising petrochemical demand and the lack of alternatives for renewable transport outside of the light vehicle market. The risk is that cartel power increases over a market which remains of fundamental importance to the world economy and global energy security.

As the European oil majors, at least, turn to more sustainable investment, and US and other non-OPEC oil producers limit new long-term spending, returning more money to shareholders in the short term, declining or pre-decline oil production will become concentrated more and more in the lowest-cost producers. This means the Middle Eastern OPEC producers and other states where government coffers, if not the whole economy, are heavily dependent on oil revenues.

It means that cartel control over the oil market will increase, while oil remains the life blood of global transportation.

OPEC+ cohesion

OPEC, or rather OPEC+, which brings Russia and some of its oil producing allies into the fold, is demonstrating a strong level of cohesion, most notably the Moscow-Riyadh axis on which OPEC+ is founded.

The creation of OPEC+ significantly extended cartel power by bringing together the world’s two largest oil exporters. Its stability, despite Russia’s invasion of Ukraine, suggests OPEC, or at least Saudi Arabia, is honing a single-minded focus on extracting every last penny from the oil market, while it still exists.

This has implications for gas, much of the traded element of which is still based on oil prices. As the IGU’s 2022 Global Wholesale Gas Price Survey Report shows, the share of gas-on-gas (GOG) pricing fell last year for the first time in years, albeit only marginally by 0.3% to 49%. In addition, the volume of spot LNG cargoes as a share of total imports also moved downward from 35% to 34%.

The good news was that the share of GOG pricing reached 46% of total LNG imports last year, up from 44% in 2020. However, this still means that the majority – 54% -- of LNG cargoes are traded linked to oil prices.

As a result, the price of more than half of the world’s LNG imports will be affected by OPEC+’s decision, announced in October, to reduce its output volumes by 2mn b/d from November.

Output cut impact

OPEC+’s decision to cut output at a time when oil prices are already high and central banks are raising interest rates to address inflation will only add to rising prices. This, in turn, threatens a more aggressive central bank response and potentially an even harsher recession. OPEC+ is attempting a squeeze against the apparent flow of the market, which is always a high-risk strategy.

One mitigating factor is that the real reductions in output are likely to be lower than the 2 million b/d headline figure, which is based on the organisation’s ‘baseline’ figures. Output is currently below this baseline. Even Saudi energy minister Abdulaziz bin Salman has put the real reduction at about 1.0-1.1mn b/d. Other forecasters, for example Goldman Sachs, have suggested only 0.4-0.6mn m/d will be removed from the market.

There are also signs that Iran, currently experiencing significant internal unrest, is moving closer to a deal on its nuclear programme. Although progress here seems ever-vulnerable to sudden reverses, a return of Iranian barrels to the market would complicate OPEC+’s decision making.

As a result, it is not the size of the headline cuts that is important, so much as what they express about OPEC+’s intentions.

Gas market pricing

The GOG element of the LNG market is sufficiently large to provide clear pricing signals. These indicate that more LNG capacity is badly needed, but it is unsatisfactory that a majority of LNG trade is still priced on a market in which cartel control appears to be on the increase.

This will continue to obscure pricing signals in the regions of the world where Oil Price Escalation (OPE) pricing is concentrated and cause a drag on the responsiveness of gas markets to real shifts in supply and demand.

It is not only LNG which is affected. OPE pricing governs 39% of global gas imports -- pipeline and LNG -- while a further 5% is based on bilateral monopolies in which there is only one dominant seller or buyer, according to the IGU’s data.

However, at present, there is little prospect of change.

GOG pricing for LNG markets is returning higher prices than OPE. It would be fair on the part of OPE buyers to argue that OPE brings benefits. They could also argue, with justification, that OPE has delivered less price volatility in the last three years, even if they missed out on the low prices caused by crashes in the LNG spot price in 2019 and 2020.

Cartel control

But let’s return to the emerging scenario in the oil market – a higher level of cartel control.

GOG pricing has made significant market inroads over the long term, rising from just over 21% of gas imports in 2005 to the current level of 56%, but this still leaves a significant proportion of the gas import market governed by oil prices. Over the longer term, increased cartel control implies artificially high rents for oil and, in turn, artificially high rents for OPE-priced LNG and pipeline gas.

Moreover, the argument that there is less price volatility only holds water in the very recent past, in which gas markets have experienced unprecedented shocks from the pandemic and then from Russia’s invasion of Ukraine and the weaponization of Russian gas exports to Europe.

These events have disrupted the longer-term trends of increased market depth and financial sophistication. These have accompanied the rise of gas-on-gas (GOG) pricing and most importantly the growth of LNG, which frees gas trade from the constraints of regional pipeline networks and provides the price transmission mechanism for global price convergence.

Looking forward, LNG is set to play an increasing role in security of energy supply worldwide in addition to the role it was already playing in allowing Asia’s heavily coal-dependent economies to switch to cleaner burning gas. Amid the current shocks, gas markets need to rebalance and to do so they need clear market signals. While every effort to protect consumers from excessive energy costs should be taken, measures which obscure market signals help no-one.

By the same token, surrendering a large portion of trade in gas imports to oil price escalation (OPC) pricing, where cartelization appears to be entering a renaissance, creates a hostage to fortune. There has been no reversal of the long-term decoupling of oil and gas markets in terms of consumption, so why should OPE continue to exist in such large form at the level of wholesale trade? Particularly so when the market on which OPE is based looks increasingly vulnerable to more aggressive cartel control.