The geopolitics of cheap oil

We live in interesting times — of geopolitical risks and curious happenings in the oil market. The Islamic State of Iraq and Syria has captured swathes of territories in Iraq, one of the major oil producers in the world. The Sunni militant group is already controlling some oil fields in Eastern Syria and the crude produced from these fields are sold in the black market.

Libya is far from stabilised. Russia, another major energy producer, is in a protracted standoff with the West over Ukraine. Geopolitical instabilities usually drive up crude prices because of the risk of supply disruption.

But just the opposite is happening now. Prices have fallen about 20 per cent in world markets since June. The global oil benchmark, Brent crude, is now trading around $85 a barrel.

The two economic reasons cited to explain this trend are an increase in oil production, mainly in North America, and an economic slowdown in Asia and Europe that has lowered demand.

China, the world’s largest energy consumer, has slowed down recently. The country is forecast to grow 7.5 per cent this year, down from 10.5 per cent in 2010. Demand from Europe is likely to remain flat as European economies are still far from a recovery.

On the production front, the North American crude is putting pressure on prices. US crude oil output is up almost 80 per cent since 2008, supplying an extra 3.9 million barrels a day (mbd). Canadian oil sands have added another 1 mbd to North American supply over the same period.

According to consultancy firm IHS, output in countries outside the Opec (Organization of the Petroleum Exporting Countries) will increase by 1.7 mbd in 2014, compared with demand growth of just 0.9 mbd.

Usually in such situations of oversupply, oil producers would cut output to prop up prices. Saudi Arabia, the world’s largest oil producer that accounts for almost one-third of the Opec’s production, had done that earlier.

But what makes the present oil price fall different is that major producers are boosting output instead of cutting it. Opec boosted production in September, pumping 30.47 mbd, the most since August 2013, it said in its latest monthly Oil Market Report on October 10. Saudi Arabia increased output 107,000 barrels to 9.704 mbd in September. Besides, on October 1, the Kingdom lowered prices by increasing the discount it offered its key Asian customers, sending a strong signal that it’s ready to live with lower prices.

However, that’s not the end of the story. Several analysts, including New York Times columnist Thomas L Friedman, had pointed to a likely global “pump war” between the US and Saudi Arabia on one side and Russia and Iran on the other. Both the Saudis and the Americans see the Russia-Iranian axis as a threat to their interests. Russia and Iran are the staunchest allies of Syrian President Bashar al-Assad against whom Saudi Arabia has been waging a proxy war with support from the West since 2011.

Besides, the Shia Iran is a traditional rival of — both in ideological and geopolitical terms — Saudi Arabia in West Asia, while the growing tension between the US and Russia in recent months is hardly a secret.

So the argument goes that the Saudis are deliberately keeping the oil prices down to hurt Russia and Iran, something which is in the strategic interest of the US as well.

As of now, Saudi Arabia is comfortable with lower prices. At the current oil prices (Brent for December was trading at $86.44 a barrel on Wednesday), their annual loss is estimated at $40 billion.

For a country that sits on foreign reserves worth almost $800 billion, this loss is manageable. But that’s not the case with Russia and Iran. Oil revenues account for 45 per cent of Russia’s budget.

The Kremlin’s 2014 budget was based on oil prices averaging $117 a barrel. For 2015, the budget has been pegged at $100 a barrel, which means the current price of below $90 is already eating into the Russian government’s revenues.

US-based private intelligence company Stratfor reported in early October, quoting Russian finance ministry officials, that lower oil prices could shave off 2 per cent of Russia’s GDP.

Iran shares the same concerns. The country needs oil prices at around $130 a barrel to balance its national budget (see the table).

The economy had been struggling for years due to western sanctions. President Hassan Rouhani got some leeway to jump-start economic growth after sanctions were eased in November last year following an interim agreement between Tehran and Western capitals.

But falling oil prices will end that momentum. In other words, while continued weakening of oil prices will not immediately affect Saudi Arabia, it will hit both Russian and Iranian economies.

The Western sanctions on Russia will have more bite, while Iran’s position will be weakened against the West in the ongoing nuclear talks.

Moreover, supporters of this plan say weakening economies may force Russia and Iran back off from extending support to the embattled Syrian regime, giving the Saudis more space to manoeuvre in the region. It’s a perfect plan. But global politics is too complicated and volatile for perfect plans.

There are two downside risks to this plan. One is, of course, the question that for how long the prices will remain low, or how long Saudi Arabia can stay healthy with lower prices.

Will the Kingdom be able to reverse the trend once it wants the prices to go up again? In the absence of a coherent strategy by all Opec countries — which is highly unlikely — it will be difficult for the Saudis alone to prop up the prices because, if the current trend persists, market will be awash with cheap oil in a few years. Then Riyadh will have to undertake huge cuts in production, which will hit its economy.

The second risk is that a possible Saudi-Western conspiracy to economically corner Russia will pivot Moscow further towards East. Putin has already sealed a $400-billion, 30-year gas deal with China.

Crude oil geopolitics will create more conditions for an enhanced Sino-Russian cooperation, which the US is already seeing as a long-term strategic threat. So it’s uncertain where this “pump war” will lead us to; what’s certain is that it’s party time for consumer countries such as China, India and Japan. And they are poised to best make use of the situation.