Paul Stevens
Distinguished Fellow, Energy, Environment and Resources

Recently there has been much discussion over the prospect of lower crude oil prices. Memories are harking back to 2008. In early July 2008, NYMEX crude hit a record high of $147/B. Six months later it had fallen to $33/B. Fears of another possible price collapse are being driven by both supply and demand factors.

In terms of demand, there is the possibility of further global economic gloom emanating from 'Groundhog Day' in the Eurozone. Recession causes oil demand to fall as it did in 2008, a process helped by the demand destruction wrought by the relatively high oil prices of the last few years – last year Brent averaged $106/B compared to $78/B in 2010 and an average of $47/B in the previous ten years. Also, the growth in Asian oil demand that has done much to support prices in recent years is also showing signs of faltering.

On the supply side, OPEC has been pumping at very high levels – in May some 1.87mn b/d over its supposed ceiling of 30mn b/d. This follows seven months of continued output growth. Leading this oversupply was Saudi Arabia. It attempted to offset the worst effects of the ill thought out EU oil embargo against Iran and the consequent price friction as European importers scrambled to find alternatives before the sanctions were enforced on 1 July.

Saudi Arabia also hoped to mute and reverse rising prices because they were seen as damaging to its long term interests by creating serious further demand destruction. Therefore the Kingdom successfully resisted demands at the last OPEC meeting on 14 June to make official cuts to OPEC output.

Price Threat

The result of all this is what appears to be an increasingly over-supplied market. This potentially threatens prices as it did in the second half of 2008. At the moment the only chance for higher prices, or even to keep them at current levels, comes from the possibility of a military strike on Iran by the Israelis – hardly a desirable state of affairs for anyone.

There is, however, a much greater problem looming for OPEC in the medium to longer term. The events of last year's Arab uprisings have left a crucial legacy. In order to pacify potentially radical populations, the governments of the major oil producers in the MENA region have had to increase public spending. Last year alone, Saudi Arabia announced increased spending amounting to some $110bn.

The result is that their 'supply price' – ie the price they need to balance the budget – has risen considerably and is likely to rise ever higher. Estimates vary, but figures for the kingdom suggest that the price of $70-80/B that King Abdullah regarded as 'reasonable' in 2008 has now risen to over $90/B. Other major producers require even higher prices with many needing over $100/B.

In light of the significant budgetary changes in key OPEC member countries Ali Aissaoui, Senior Consultant at the Arab Petroleum Investments Corporation, revisited fiscal break-even prices in his latest MEES Op-Ed and looked at what light they shed on OPEC policy (MEES, 13 August). He notes that median estimates of fiscal break‐even prices for 2012 vary from $53/B for Qatar to $127/B for Iran. In between, Saudi Arabia's break‐even price is estimated at $94/B, slightly lower than the OPEC output-weighted $99/B average.

Demand Destruction Fears

The current historically high prices will have two effects. They will continue to create oil demand destruction. Already OECD oil demand has peaked as eventually it will in emerging market economies as higher prices are passed on to consumers. The IEA estimated in its New Policies Scenario that 68% of future oil demand growth in the non-OECD in 2009-35 will come from the MICs (Middle East, India and China). These have all had a long history of highly subsidized domestic oil prices encouraging dramatic growth in oil demand. This is changing. India began the process of moving towards international price levels in 2002; China in 2009 and many MENA countries are considering raising prices. This will slow oil demand growth.

At the same time, lurking in the background is the possibility of further supply increases in response to higher prices. This would come from the application of technologies associated with the 'shale gas revolution' in the US to the production of liquids and the development of unconventional oils more generally.

Thus some analysts are now suggesting that North America could be moving towards oil independence in the foreseeable future. This is an idea that only four or five years ago would have been regarded as lunatic. The in-joke last year among oil market watchers was that North Dakota would be the next member of OPEC. In 2011, North Dakota produced more oil than OPEC's Ecuador! 

Thus the dilemma is simple. OPEC countries' governments need higher prices to survive politically but, at the same time, these higher prices will sow the seeds of their destruction. While the OPEC ministers are rather shrugging this of as an issue, deep down they do understand the threat. They need the golden egg but they need it at a rate that may well kill the goose.

This article originally appeared on the Middle East Economic Survey (MEES).

Also read:

The 'Shale Gas Revolution': Developments and Changes, Paul Stevens, Briefing Paper, August 2012

The Arab Uprisings and the International Oil Markets, Paul Stevens, Briefing Paper, February 2012

An Embargo on Iranian Crude Oil Exports: How Likely and with what Impact?, Paul Stevens, Programme Paper, January 2012