How Falling Oil Prices are Aggravating Economic and Political Uncertainties

The old producers v. importers game has made way for complex, intersecting faultlines in which geopolitical and commercial rivalries are taking their toll on the stability of the global oil market

The last 15 months have witnessed some dramatic developments relating to oil prices. They began to fall from a high of $115 a barrel in June last year to $40 in January this year, a decline of 60%. For a short while, they rallied in mid-January at around $ 60, and then fell; they rallied again at $65 in May-June, and then reached a low of $42 in late August. Since then, they have crept upwards and hover around $ 42-50 a barrel. These price fluctuations have taken place at a time when much of the world is experiencing turmoil in both the economic and political areas – the global economic downturn and a continuing pessimistic outlook; armed conflicts in Syria, Yemen, Libya and Iraq, and the proliferation of extremist elements across South and West Asia and north Africa.

Historical precedents

Analysts have struggled to explain these bewildering price fluctuations. Some have attempted to find an explanation in history. Similar price declines have taken place on three occasions earlier. In 1985-86, there was an oversupply in the market, mainly due to production from the North Sea. At that time, Saudi Arabia, as the “swing producer”, drastically cut production, but supplies continued, and prices plummeted from $30/b to below $10 in just eight months between November 1985 and July 1986. In 1997-98, the price crisis was caused by a short-term collapse in demand due to the Asian meltdown. But there was a quick recovery, supported by significant increases in demand from China and India, which pushed up prices once again. The third crisis in 2008-09 was caused by the global financial slowdown which led to a global downturn in demand. Prices fell rapidly from a  height of $140/b to reach a bottom of $ 30/b. But, this drop was stemmed due to cuts by producers, increasing demand encouraged by various fiscal stimuli, and growth in the emerging markets led by China and India.

Observers see in today’s situation similarities with the first crisis, i.e., price fall due to oversupply. This is primarily due to US shale oil production. The figures in this regard are telling: since 2008, US oil production has increased by 80% or 4 million barrels per day (mbd), so that its oil imports have fallen from 60% to 20% of total consumption, averaging 19 mbd in 2014. US government sources believe this trend will continue: they now forecast that in 2025, the US will import 14 mbd less than what had been predicted less than a decade ago.

While US shale oil has been making its presence felt in the oil market for some years, the global demand-supply situation had remained balanced due to reductions in supplies from Iraq and Libya due to domestic conflicts. In June last year, the market suddenly witnessed significant increases in supplies from these two countries, in addition to the increased US production. This ignited the price fall, which has continued steadily over the next several months.

OPEC versus shale oil

It had been widely anticipated that at the OPEC Oil Ministers meeting in Vienna in December 2014 significant cuts in production would be announced. However, OPEC, led by Saudi Arabia, has adopted an unprecedented posture: rather than opt for production cuts, which is what it used to do in past, it has decided to let the market decide the price – while maintaining production to protect market share. Thus, the oil market is experiencing the unique situation of being awash with supplies from OPEC and non-OPEC sources. There has been a surge in OPEC production: it was 31.75 mbd in June, an increase of 310,000 b/d over the previous month; it rose to 31.92 mbd in July before falling slightly to 31.88 mbd in August.

The immediate effect of this has been a massive decline in the revenues of OPEC producers: assuming an average price of $60/b for 2015, revenues are expected to be $560 billion – a fall of 42% over last year, and half of what had been earned in 2012. However, if we assume a more realistic price of $52/b, OPEC revenues will be lower by a further $30 billion.

There has been considerable speculation about the motives driving Saudi policy. Late last year, there were self-serving assertions in the US media that Saudi Arabia was working in tandem with the US to put pressure on Russia and Iran to be more accommodative, respectively, in Ukraine and in the nuclear discussions. But, this was soon given up when it was seen that the low prices were actually hurting US producers of shale oil too – who need oil prices of about $70-80/b to be commercially viable.

The Americans had every reason to be concerned. In March this year, Saudi Oil Minister Ali al-Naimi made his country’s position clear when he said: “It is not the role of Saudi Arabia, or certain other OPEC nations, to subsidise higher cost producers by ceding market share.” This position was based on the belief that Saudi Arabia and other low-cost producers (mainly the Gulf countries) were better placed to cope with low prices than high-cost unconventional oil producers such as the US (shale oil), Canada (oil sands) and Brazil (ultra-deep water oil).

In this complex scenario, analysts are confused as well and revise their forecasts of production and prices practically from month to month. In May, for instance, even as there was a sharp fall in US rig use and an attendant fall in production, the International Energy Agency (IEA) – the Paris-based energy arm of the OECD consuming countries – forecast increases in non-OPEC production (mainly from Russia, Brazil and China) of about 200,000 barrels per day (b/d) over its previous month’s estimate to a total of 57.8 mbd. The IEA then asserted: “It would thus  be premature to suggest that OPEC has won the battle for market share. The battle, rather, has just begun.”

However, within three months of these gung-ho remarks, the impact of low prices finally hit US production severely: the US government’s Energy Information Agency (EIA) reported in early September that production had fallen further and faster than predicted earlier, with losses of $30 billion being sustained by shale oil producers in just the first six months of this year; this followed a deficit between income and expenditure of $37 billion last year. The  EIA noted that US output in August had been 9.06 mbd, about 550,000 b/d less than the peak of 9.61 mbd in April. The EIA also  projected US production of 8.8 mbd for 2016, about 800,000 b/d less than earlier peak production, and 550,000 b/d less than its forecast just two months earlier. The EIA expects US production to be restored to reach an average of 9.6 mbd by end-2016.

Long term investments in unconventional oil exploration have also been curtailed, since these are not viable unless prices are over $60/b. According to reports, oil majors have postponed investments of about $200 billion in 46 projects, denying considerable new supplies to the market. For instance, the development of Mexico’s reserves of about 20 billion barrels has been indefinitely postponed.

Market uncertainties

Does this mean that OPEC has won the price battle and we can now expect greater stability in the global oil market? Not so; there is in fact every indication that market uncertainties will continue for some years to come. First, regardless of the concerns of OPEC producers, shale oil is now a key presence in the global oil economy; some observers even believe it could be the “swing” producer in place of Saudi Arabia. Though adversely affected by low prices, its producers have shown considerable resilience, primarily due their capacity to effect increasing efficiency and economy in the production chain, so that they can now increase production even at prices of around $60-70/b. In fact, in anticipation of better market conditions, US companies are now drilling wells but not producing for the moment, hoping to swing into action quickly when prices improve.That said, in response to price fluctuations, shale producers do not have the ability to increase (or decrease) production with the speed that conventional producers can: while Gulf producers can increase production in a few weeks, US producers can take up to six months to achieve this.

Second, there are serious challenges before the producers of the Gulf Cooperation Council (GCC) as well. While their cost of production is the lowest in the world ($ 5-10/b), their dependence on oil revenues is significant: for instance,oil revenues provide 90% of Saudi budgetary revenues and constitute 43% of its GDP. It however also has a buffer of foreign exchange reserves of $740 billion, which is the cushion to sustain low prices.

But, the Kingdom’s problems are complex and multi-faceted. In spite of high production, it now has less and less oil to export: its domestic consumption has increased by 7.5% per year over the last five years, with considerable inefficiency in energy use. Its energy consumption per unit is four times that of energy efficient countries such as the UK and Germany. It is a major user of oil for electricity: 58% of the country’s electricity comes from oil, consuming 0.8 mbd of oil per year, and expected to rise to 1 mbd in five years.Again, at least 2.2 mbd of its oil is going to its refineries. Thus, in April, Saudi oil exports in June were 6.4 mbd, lower by 400,000 b/d compared to June last year. In spite of a record production of 10.2 mbd in the first half of 2015, Saudi exports were 7.94 mbd, a mere 3% increase over the same period last year. It is projected by some observers that in 2020, Saudi Arabia may export less than 5 mbd in spite of a record production of 10.3 mbd in that year.

The Kingdom also faces the grave problem of energy subsidies: the loss in revenue on account of subsidies is estimated at $ 80 billion. Finally, as a welfare state, Riyadh also has social commitments such as unemployment, retirement and social security  benefits, valued at about $20 billion annually which, due to political compulsions, just cannot be curtailed.

Low oil prices, coupled with increasing domestic consumption, subsidies and social commitments, have aggravated the country’s fiscal deficit. The IMF has projected that the Saudi fiscal deficit in 2015 will be $126 billion or 19.5% of GDP, and has recommended “comprehensive energy price” reforms. To meet this challenge, the Kingdom plans to raise debt locally of about $30 billion. It has also drawn on its reserves: $60 billion was drawn in the first six months of this year, so that reserves stood at $664 billion at the end of June. Most observers believe such deficits are sustainable only in the short term, otherwise the country’s credit rating would be adversely affected. They have suggested drastic cost-cutting, privatisation of some state enterprises and reductions in subsidies, none of which have found favour with Saudi policy makers in the past.

Geopolitical concerns

The third area of uncertainty is the entry of Iran into the global oil market following the easing of sanctions. Iran has reserves of about 158 billion barrels of oil, about 10% of world reserves (as also 34 trillion cubic metres of gas, nearly 20% of world reserves). Its production in 2011, before sanctions targeted its oil industry, was 3.6 mbd; this fell to about 2.8 mbd today, of which 1.1-1.2 mbd is exported. Its oil minister, Bijan Zanganeh has frequently asserted that Iran would be able to double its production within a few months of the lifting of sanctions. He has also reminded commentators that Iran will not relinquish its right “to reclaim its rightful share of the market”. He has said: “If Iran’s oil production increase is not done promptly, we will be losing our market permanently”, a timely reminder that market share is not just a collective OPEC concern, and that within OPEC too there is competition  among major producers. However, observers believe that the impact of the lifting of sanctions on Iran may be felt only in early 2016, when 300,000-500,000 b/d of additional Iranian oil could enter the market, with another 500,000 b/d coming into the market by the end of the year. These new supplies will certainly depress prices, though the extent cannot be safely predicted due to uncertainties relating to shale oil and GCC supplies. Iran is also looking for an investment of $200 billion to upgrade its hydrocarbon sector.

In the already fraught scenario in West Asia, with producers under considerable economic and political pressure due to low prices, the fourth source of uncertainty is the security situation across West Asia and North and Sub-Saharan Africa, the world’s principal sources of oil.

Three wars are raging in the region – Syria, Yemen, and Libya. While jihadi groups have expanded their sway across the region and are in conflict with established state authorities, their areas of influence include Iraq, Syria, Yemen, Somalia, Libya, Algeria, and parts of Nigeria. In a recent report, the Middle East Economic Survey has said that the presence of terrorist movements across North Africa, particularly Libya, “threatens to destabilise the whole region”. It notes that  political instability and actual attacks on oil facilities and foreign workers have heightened risks in the region which will only increase unless immediate action is taken to dislodge ISIS before it consolidates itself.

At the heart of the contentions in West Asia is the deep divide between the regional giants (and the world’s major oil producers) Saudi Arabia and Iran. The Kingdom senses an “existential threat” from Iran and has framed its confrontation in uncompromising sectarian terms which include direct military intervention in Yemen, mobilising Salafi militias in Syria and, in ground operations, even working with jihadi groups.

Even now, an attack on an oil facility can lead to the withdrawal of various quantities of oil from the market and  push prices upwards. A major escalation in the ongoing proxy wars could jeopardise the regional oil economy, lead to extraordinary economic and political  disorder across Asia, and paralyse global economic activity. While the ongoing contentions are for now contained within specific geographical spaces, we can see no sign of any diplomatic effort to bring the two regional rivals to the negotiating table.

Outlook for the global oil economy

Bloomberg, in a mid-September assessment has concluded: “The Saudis are winning, though they are paying a heavy price for it.” It notes that the number of active rigs in the US has fallen by 40% from last year. It also points out that shale oil production just does not offer lower marginal costs that can tide over an industry over the short term: shale oil wells dry up very fast, with production declines of 72% taking place in one year (and 82% in the first two years of operations). To increase or even to maintain output, continuous investments are required, now more difficult to obtain due to the low prices.

What then is the near term outlook for the oil economy? OPEC has forecast a fall of 110,000 b/d in non-OPEC production next year, while still maintaining a slight increase 160,000 b/d over this year. The IEA surprisingly predicts an overall decline of 550,000 b/d in non-OPEC production, the largest fall since 1992. OPEC also believes that global demand next year will increase by 1.2 mbd. Thus, it feels that an increased OPEC production by 200,000 b/d, yielding a total of 30.3 mbd would be be sufficient to meet global market requirements, though this figure is still 1.2 mbd less than the OPEC production in August, which was 31.54 mbd.Thus, without some production cuts, pressure on prices will remain.

The outlook  for prices is uncertain. Goldman Sachs has made a long term forecast of $50/b, though it has also warned that prices could collapse to below $20/b if action was not taken quickly to curtail production. OPEC, on the other hand, has forecast prices of $80/b by 2020, mainly on the basis of declines in non-OPEC production of about 1 mbd as early as 2017. The oil consultant, Gary Ross, who had predicted last year’s price fall, had now asserted that prices would “bounce back to $100/b in five years”. Ross bases his forecast on the  absence of sufficient spare capacity in Saudi Arabia, disruptions to supply due to geopolitical threats,and increases in global demand of 1.7 mbd this year and next year.

A new Opec approach?

There is now an increasing chorus of voices calling for the OPEC to review its do-nothing approach. Even the normally sedate Middle East Economic Survey  pointed out in late-August that this approach “has left the market rudderless and without direction”. An editorial in the Dubai-based Gulf News asserts that “OPEC has lost its way”. It criticises the organisation for abandoning its central purpose of safeguarding the revenues  of its members in favour of a “panicky attempt” to grab market share from shale oil producers, leading to a “disaster” for its members. It calls for a new strategy based on providing stable markets and a steady income for its members.

These concerns have been articulated by other GCC commentators, though in  more muted form. A Saudi commentator, Salah Khashoggi, has expressed alarm at the present scenario, pointing out that the war with shale oil will take much longer than expected, while the Kingdom’s parlous economic situation presents a “dark picture” of the country. He has called for reduction in domestic consumption and subsidy reform, and, in a novel recommendation, has urged introduction of real estate taxes on unused land which could generate $ 50 billion – around 10% of the annual budget.

A Kuwaiti commentator, Mohammad al Rumaihi, anticipates that the “crisis” will last for a long time. However, he sees a silver lining in this: he suggests that the GCC countries use the opportunity to pursue “real development”, particularly diversification of the economy away from oil, replacement of expatriate workers with locals, an end to subsidies, and, above all, an end to the regional conflicts that have raged for the last four decades – in short a “serious restructuring” of the regional order.

There has also been a flurry of diplomatic activity, mainly by leaders of OPEC member-countries most seriously affected by the low prices, such as Venezuela, Nigeria, Algeria, Iran and Iraq – which have from time to time called for a  review of OPEC policy. Venezuela has led this effort but has not got any positive response from Saudi Arabia. Outside OPEC, Russia, which earlier had been most vocal in criticising the Saudi position, is no longer in favour of production cuts: in fact, from early this year, it has increased  its production, with output presently at 10.68 mbd.

The Saudi position remains that OPEC alone should not effect production cuts: its share of the global market has already shrunk from 34% in 2012 to 32% in August; further cuts would only erode its share, without having a significant impact on prices, since non-OPEC producers would quickly make up the shortfall. As of now, even the IEA believes that the Saudi approach has been successful in driving costly, ‘inefficient’ production out of the market. However, with OPEC maintaining record levels of production, it is unlikely that there will be much change in prices next year. The war on shale oil will continue for some more time.

Talmiz Ahmad is a former Indian ambassador to Saudi Arabia and the United Arab Emirates