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The boys from the black stuff

COMMODITIES: Some think that Opec delegates seeking assurances on near-term Saudi Arabian production cuts are in for a crude response, as divisions over the current quota strategy intensify
June 5, 2015

Opec delegates meet in Vienna on Friday to discuss, among other things,* the contentious issue of production quotas. It has been widely assumed that Saudi Arabia - as de-facto leader of the organisation - will maintain output at existing levels, despite increased pressure from other member states for it to tighten supply and bolster prices.

The only trouble is that the strategy - designed to cripple US shale production - could take much longer than expected to effect permanent change. While some lower-margin production has been squeezed out of the market, and the US rig count is down for the 25th successive week, non-Opec supply is still growing. Worse still - from a Saudi perspective - there are now signs of increased elasticity where US shale supply is concerned.

So it's just as well that this month's meeting is being run in parallel with the periodic two-day International Opec Seminar, which is open to representatives of non-Opec producers, such as Russia, Norway, Mexico and Brazil. The streets of Austria's capital will be slick with oil folk from across the globe, but whether this might engender a co-ordinated response on the subject of quotas is anyone's guess.

It's more than six months since the Desert Kingdom effectively abandoned its role as swing producer for the cartel, in favour of a strategy designed to shore up its long-term market share by hobbling unconventional output in North America. The jury is out on whether the Saudis have prompted permanent change, but the strategy has certainly had a wholly detrimental effect on many of Saudi Arabia's partners in Opec.

 

Riyadh has 'em over a barrel

The Vienna gathering presents an opportunity for the big producing nations - and industry representatives - to try to reach a comprehensive production agreement to stabilise crude oil prices. To ensure that Brent crude trades broadly within the $60-$80 a barrel range, around 1.9m barrels a day will need to be trimmed from global supply, although the mismatch between supply and demand could increase substantially if a deal is finally reached over Iran's nuclear programme.

Ideally, it would be preferable if all national producers were to take a share of the pain on the production front. If the cartel was to go it alone, the equation is fairly straightforward: Opec (ergo Riyadh) would either need to peg back daily output by around 6.3 per cent, or the industry will endure depressed oil prices for a prolonged period. Saudi Arabia, with its huge capital reserves and low production costs, could live with depressed oil prices through the remainder of 2015 and beyond. But with other cartel members, most notably Iran and Algeria, the imperative to cover current spending commitments is far more pressing. But judging by previous meetings, the assembled delegates are about as likely to reach an equitable accord as would two dogs fighting over a bone - we shall see.

 

Opec production, spare capacity & break-even levels
CountryQ2 supply (mbod)Spare capacity (mbod)US$/barrel Break-even rate (consensus)
Algeria1.110.03131
Angola1.680.1297.8
Ecuador0.550.0278.4
Iran2.880.72130
Iraq3.800.00101
Kuwait2.800.0255.6
Libya0.520.00123
Nigeria1.800.1262.3
Qatar0.690.01106
Saudi Arabia1.102.2475.6
UAE2.840.06117
Venezuela2.440.05101
Total Opec31.213.39na
Source: API

 

Norway's ethical divestment

Meanwhile, just as Opec delegates are getting down to their Sachertorte, 1,700 kilometres to the north, Norway's parliamentarians will be asked to ratify proposals that could impact investment flows into another key fossil fuel - coal.

Under regulatory amendments being placed before the parliament's finance committee, Norway's massive sovereign wealth fund would be required to hive off investments in any companies that generate at least 30 per cent of their revenue from coal mining or coal-fired power generation. The move will affect around $10bn of coal-related investments, according to the Norwegian government.

This is being seen as the most significant development for proponents of the nascent fossil-fuel divestment movement, although one suspects that the main function of this campaign - as with so many others - is to highlight the moral rectitude of the eco-warriors, rather than the propagation of any genuinely practical alternatives.

The Norwegians themselves seem to have conveniently forgotten how the $896bn held in the Government Pension Fund of Norway got there in the first place - perhaps they should consider dumping their holdings in Statoil while they're at it. Regardless of Norway's selective amnesia on emissions, the move will amount to little more than window dressing unless levies are eventually applied on fossil fuels on the basis of their global environmental impact. This would theoretically shift investment towards cleaner sources of energy, although the incidence of emphysema and chronic bronchitis in the People's Republic of China will probably have a more telling impact over the long run anyway.

 

Have metals bottomed out?

It's not so much cautious optimism as tempered resignation from commodity analysts at Macquarie Research: "Commodity markets are starting to let through some rays of light… adequately supplied… demand expectations still falling… little need for immediate excitement.” Hardly very effusive, but the institution's latest analysis does suggest that prices for most mining commodities (with the exception of both coal and tin) are likely to have bottomed out by the end of the third quarter and should begin to retrace through 2016 and beyond. Macquarie estimates that the majority of metal and bulk commodities are "over three years away from needing new supply over and above that already committed", although there are some exceptions.

 

Nickel and dime prospects

Nickel, for instance, looks a compelling recovery play, with the full-year pricing assumption for 2015 at $15,209 a tonne, against an average rate of $23,325 through 2016-20. Nickel's prospects do look favourable over the long run, although prices are currently held in check through an unexpected increase in ore supply. But management at MMC Norilsk Nickel (the world's largest producer of nickel) believe that China's inventories of nickel ore now amount to just two months of consumption. The metal's prospects are also being boosted by a significant rise in trading liquidity following the recent introduction of a nickel contract on the Shanghai Futures Exchange (SHFE).

This SHFE issue also points to a rapid, although perhaps not terminal, shift from West to East in physical metals markets, with volumes on the SHFE eclipsing that of the London Metal Exchange (LME) - the world's oldest metals exchange. (It is possible to gain exposure through Barclays' iPath Bloomberg Nickel SubTR ETN, although the instrument does not qualify for Isa status).

 

 

Regardless of an aggressive sell-off in the early part of this year, market fundamentals for copper are also positive; a small deficit (37m tonnes) is now expected this year due to flooding in copper-mining areas in Chile's Atacama Desert. Ironically, before the torrential rains, copper production was being constricted by a prolonged drought, which had forced authorities to impose water restrictions. Beyond this year, modest surpluses are expected in 2016-17, but in 2018 it is anticipated that the copper market will be in deficit to the tune of 180m tonnes, which should then double in each of the following two years. In short, fundamentals suggest that copper prices could rise by around a third between now and 2019.

 

Rio gets the nod for Oyu Tolgoi

With the copper market set to effectively move into equilibrium somewhat sooner than expected, the timing of Rio Tinto's (RIO) accommodation with Mongolian authorities over the Oyu Tolgoi project couldn't have been better. Oyu Tolgoi is one of the world's largest copper deposits, but a multibillion-dollar underground expansion of the mine has been in limbo for more than two years due to disputes between Rio Tinto and the Mongolian government over revenue- and cost-sharing arrangements. Although production from the expansion is unlikely before 2020, it will transform the Anglo-Australian miner's commodity mix by reducing its reliance on iron ore.

The proximity of Oyu Tolgoi to China is highly advantageous as Beijing moves ahead with a massive expansion and upgrade of the electricity grid. The State Grid Corp of China (SGCC) is set to spend 420bn renminbi (£44.6bn) on grid infrastructure this year, representing a year-on-year increase of 24 per cent, according to the state-run Xinhua News Agency. And it doesn't end there; the work will prefigure the launch of four major power links connecting China with Kazakhstan, Russia, Mongolia and Pakistan. We mightn't see a return to the copper-bottomed returns from the early part of the new millennium, but the portents for the metal are certainly positive. There is speculation that some Chinese copper demand will be lost due to new industry standards issued by China's National Energy Administration. They have effectively cleared the way for the use of cheaper aluminium alloy power cables to connect buildings to substations, but the likely level of substitution is impossible to quantify at this stage.

 

So on to Antwerp

A recent update from Stellar Diamonds (STEL) on auction results linked to its Baoulé kimberlite pipe in Guinea suggests that prices on higher-quality stones have stabilised following the general fall-away during the latter months of 2014. The latest sale garnered an average price of $156 per carat, against a previous rate of just $110 per carat. It's good news for the Aim-traded minnow, which is moving close to the point where it will be able to assign realistic valuations on the Baoulé pipe.

But wholesale dealers remain circumspect following last year's decision by KBC Groep NV to wind down its Antwerp Diamond Bank. For the best part of a century, the bank had been a vital source of finance to the network of wholesalers and cutters that ply their trade in the Flemish port city.

Diamond markets have remained relatively subdued through the second quarter. Until recently, suppliers hadn't lowered prices even though liquidity and finance remain tight. But reports have emerged that De Beers, the world's largest diamond producer, cut the price of gems at its latest sale. This comes as something of a surprise given that the company had previously vowed to peg back output this year to bolster prices. However, the attached price estimates produced by New York-based industry expert, Paul Zimnisky, does suggest the positive long-run price narrative remains in place.