New York: On this day in 1973, Opec’s Arab members launched an embargo against the US and other Israeli allies, kicking off a transformation in the global oil market. The aftershock can still be felt more than 40 years later in this weekend’s $12.9 billion deal involving Russia’s Rosneft, commodity marketer Trafigura and a large Indian refining and marketing business owned by Essar Group.
In that context, Rosneft’s Indian coup may well be a tactical victory, but not one that solves a wider strategic problem.
The 1973 embargo was the first real display of Opec’s power, epitomizing a big underlying shift in the oil market. Up until the 1970s, there was no oil market as such. The traditional majors—Exxon, Royal Dutch Shell, British Petroleum, Chevron and a few others—controlled virtually all oil production and the majority of refining capacity outside of the US and communist countries. That closed, vertically integrated system was broken up as governments of large oil-producing countries first demanded the power to negotiate prices and then nationalized oilfields outright.
Also read: Why has Rosneft paid a packet for Essar Oil?
Among many other things—notably massive demand destruction and new supply from non-Opec regions—the ensuing tumult helped spur the creation of a true market in oil. Nymex launched a futures contract for West Texas Intermediate crude in 1983, enabling producers to hedge their cash flows and speculators, such as commodity-trading firms, to take bets on future prices. In attempting to control oil prices, Opec spurred the creation of tools undermining this very objective.
Fast forward to 2016, and the effects are still being felt. This generation’s oil shock, roughly from 2004 to 2014, also spurred big shifts, most notably the shale boom in the US. As I wrote here, E&P firms have been helped enormously by those same energy futures markets, and US capital markets, enabling them to drill far beyond what their own cash flow could have supported. Meanwhile, the shock also spurred efforts to wean consumers off oil and provided more ammunition for environmentalists.
The result is a new equation for global oil: More supply plus fear of future demand shocks equals fierce competition for markets.
Which brings us to Rosneft’s deal. The Russian major reportedly beat off competing interest from Saudi Arabia and Iran. India’s attractions are obvious:
Being obvious, though, India’s attractions haven’t been lost on the world’s oil producers, especially in this newly competitive environment. Before 2008, BP didn’t even bother to break out India as a separate destination for oil exports in the company’s annual statistical roundup. Since then, foreign oil flows to India have jumped by almost half—and the composition has shifted dramatically:
The same dynamic has played out in that other behemoth, China, where rising production from the Americas has led to fierce competition between producers in the Middle East, Africa and the former Soviet Union:
So Rosneft’s deal is a tactical victory in several respects. It demonstrates that, even as Ukraine-related sanctions block Rosneft on some fronts, it isn’t boxed in entirely. This fits with other moves by Russia and Rosneft to deepen ties with Indian oil companies, which offer an alternative to Western capital.
Rosneft also obviously gains a strong foothold in a growing market and a refining asset that can also export products such as gasoline and diesel to other markets as the opportunity arises. Just as importantly, Rosneft’s ownership of the Essar assets will close them off to rivals such as Saudi Arabia.
This form of vertical integration is also a response to the strategic challenges presented by a more competitive market for oil, though. Rosneft isn’t the only one doing it. Saudi Aramco, for example, wants to expand its storage capacity in China and Japan to strengthen its position in two key Asian markets. Aramco is also reportedly the leading bidder for Lyondell Basell’s Houston refinery.
Yet even if Rosneft—or Aramco or anyone else—gains some short-term advantage by piecing together exclusive supply chains, the knock-on effect over time will be for other refiners to bid down the price of barrels from other producers who now have fewer channels to market.
Energy economist Phil Verleger points out that some producers could be more vulnerable than others; for example, heavy oil coming from such places as Canada or Venezuela can only be processed by sophisticated refineries, so those countries could face a squeeze. Overall, though, it doesn’t solve the problem of more competitive upstream oil supply. Indeed, on that front, the battle for Essar stands in marked contrast to recent talk of cooperation between Russia and Opec on supply cuts.
Ultimately, the need to buy market access and optionality in this way mirrors what has happened over time with other commodity markets, from grain to metals. As innovations in information technology and financial markets have made it harder and harder to maintain an edge in trading raw materials, some large commodity marketers such as Glencore, Louis Dreyfus and, indeed, Trafigura have invested more in physical infrastructure such as mines, ports and refineries to keep it.
Oil, now apparently bereft of the stabilizing influence of Opec or those all-powerful majors that preceded it, has become just as competitive. Rosneft has secured the support of traders in pulling off its Indian coup. But their critical role in the deal itself signals the world that got blown up in the 1970s can’t be put back together again. Bloomberg
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