Weekly Commentary

Caught in the liquidity trap

July 2023 The recent slight increase in oil prices should not obscure the fact that OPEC Plus has lost a massive amount of influence and the oil price is likely to fall in the long term.
A comment from Dr. Cyrus de la Rubia

Dr. Cyrus de la Rubia

OPEC is often compared to a central bank. While the central bank regulates interest rates by varying the money supply, the oil cartel tries to control oil prices by changing the oil supply. Sometimes central banks get into a situation where they are no longer able to keep interest rates down by increasing the money supply. They then find themselves in a liquidity trap - the years of zero interest rates send their regards. OPEC now seems to be in a similar trap. The alliance is trying to reduce the volume of oil, but in so doing is running into the void, and oil prices are not reacting as desired. Instead, it can be seen that prices have fallen, rather than risen, following the sharp reduction in production quotas in November last year and further voluntary production cuts.

Decline in demand in industrial sector

There are very different factors at work here. First, OPEC Plus (OPEC plus partners, which includes Russia) and Saudi Arabia, as the main players in OPEC, are trying to combat a weakening global economy with the cuts they have decided to make, but one in which the thirst for oil is just declining. This is especially true since the global economic downturn has hit the industrial sector, which is responsible for about one-third of global oil consumption, particularly hard. The fact that China's opening up at the end of last year resulted in only a moderate growth stimulus is also not helpful, since the country is a key player in this market with a share of around 15% of global consumption.

Unstable cartel

Second, Saudi Arabia is losing authority and assertiveness within the OPEC Plus grouping. This can be seen, among other things, in the fact that the country has recently only been able to implement voluntary production cuts, which lack even more binding force than the quota cuts. This, in turn, is due to the current difficult constellation of circumstances. For one thing, the inherent instability of a cartel is most pronounced when prices fall. This is because most OPEC Plus countries rely on oil revenues. If these decline because of lower prices, then the normal impulse would be to expand production to stabilize revenues. If they stick to the agreed production volumes, this hits twice: less volume at lower prices. Second, given the war of aggression it has launched, Russia has other interests and probably a different time horizon than the average OPEC Plus country. The country has to calculate with oil valuations significantly below the usual oil prices anyway due to the sanctions and the price caps agreed by the G7 countries. Voluntary production cuts are promised under these circumstances in order to at least verbally stabilize prices, but sticking to the guidelines is another matter altogether.

Sustained failure to meet targets

Third, the OPEC Plus countries have already been in the unfavorable position since the middle of last year that, on average, they were no longer able to meet production quotas at all. In October 2022, the member countries were supposed to collectively produce about 44 million barrels per day of oil. In fact, they produced just over 40 million barrels per day. Then, when there was a significant downward quota adjustment in November 2022, it did little to change actual production; primarily, the target shortfall fell. That's kind of like being given an air rifle with a range of 80 meters to shoot at a target 200 meters away and now being told to get within 150 meters of the target. They will not hit the target in either case, they will only approach it.

One man's sorrow is another man's joy

Fourth, of course, it should be noted that other countries outside OPEC Plus are not watching idly. Basically, the other producers are rubbing their hands: let the oil cartel reduce its production quotas, they can then gain market share in reverse. In fact, since November, OPEC Plus production has fallen by around 2 million barrels per day, while production in the other countries - the data here is unfortunately incomplete - is likely to have risen by a similar amount. And the USA has also successfully resisted the shortage of crude oil by temporarily releasing part of its strategic oil reserve.

When will the tipping point occur?

And finally, politicians are about to usher in the end of fossil fuels. This is most evident on our roads, where the number of e-cars on the road is increasing. Considering that the transportation sector consumes about 60% of the world's oil, the trend toward more e-mobility is causing a decline in oil demand, or at least slower demand growth. If oil producers realize that oil could become worthless at some point, it would be quite possible for some countries to try to get oil out of the ground "at the drop of a hat," and the oil market could then temporarily collapse. We are not there yet, but no one can say exactly when this tipping point will be reached.

Back to the liquidity trap. For a whole ten years, the eurozone was more or less caught in the liquidity trap, after deposit rates had even been screwed into negative territory. Can this also happen in the oil market? There are many indications that it could. The biggest risk is that investments in the oil sector will be massively cut back, so that phases of oil shortages may occur again and again. However, we do not expect the oil sector to escape the trap on a sustained basis.

Dr. Cyrus de la Rubia

Chief economist


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