Two new dimensions to international oil markets are creating a real dilemma for OPEC and may be sowing the seeds of a major oil price shock. The first is the fall-out from the 'Arab Uprisings' that began early in 2011, and the second is the development and application of shale technology – horizontal drilling and hydraulic fracturing or 'fracking' – to oil production.
A major consequence of the political upheavals in the Arab world is that oil producing governments need more revenue to assuage and divert potential popular unrest. For example, Saudi Arabia has started hiring Saudi nationals in its public sector after a period in the 1990s of trying to force the Saudi private sector to absorb the growing number of nationals entering the job market. These nationals have also been awarded significant pay increases.
Saudi job creation stretches public finances
Between 2002 and 2011, the number of Saudi nationals employed in the public sector rose by 41% while current government spending in the same period rose by 146%. All this requires higher prices, reinforced if production is curtailed to defend prices. For example, in 2008 it was estimated that Saudi Arabia needed around $50/B to balance the books. An estimate for this year puts the fiscal break-even price at $98/B, up $4 on 2012 (Ali Aissaoui, 'Modelling OPEC's Fiscal Break-even Oil Prices: New Findings and Policy Insights,' MEES, 29 July 2013).
However, such high prices will produce market responses and this is where shale technology comes in. This relatively high cost technology (estimates of production costs in the US range from $40 to $85/B) has led to a dramatic increase in oil production, most obviously in the US. BP's latest Statistical Review of World Energy, released in June 2013 shows that 2012 saw the highest single year increase in US oil production ever recorded. For the first time since the idea first emerged in 1973, US 'Energy Independence' has become a real possibility. High prices will also promote the development of conventional crude producing capacity adding to the potential for increased supply.
At the same time as supply is increasing, high prices will also lead to oil demand destruction. This is different from reduced demand as the result of economic recession. When the recession is over, oil demand returns. However, in the case of demand destruction it is lost forever. In particular the impact is likely to be felt in the 'MICs' – Middle East, India and China. The MICs, according to the International Energy Agency (IEA) in the 'New Policies Scenario' of its 2013 World Energy Outlook, are expected to account for 68% of the increase in non-OECD oil demand between 2011 and 2035.
India, China cut subsidies
However, historically all three have had highly subsidized domestic oil prices that encouraged very high levels of oil demand growth. This has been changing. In India the process of removing subsidies began in 2002 and in China in 2009. Price reform in the Middle East is under discussion in many countries but is constrained by concern over possible further popular unrest. With price reform in the MICs, the higher prices needed by OPEC for political survival (prices which since 2002 have by and large materialized) will be passed onto consumers. Thus the crude price has risen inexorably, from $25/B in 2002 to $112/B in 2012, albeit with the trend upwards accompanied by rising volatility. The price paid by the final consumer is amplified further as consumer governments realize the scope for raising revenue by imposing sales taxes on oil products, as is the norm in OECD countries. Oil products are an ideal source of tax revenue. They have a large tax base; an inelastic demand allowing high tax rates; and very low collection costs. Politicians can also impose them whilst hiding behind the banner of environmental protection. China explicitly suggested the raising of such taxes in 2009 when it announced oil price reform. These higher consumer prices will impact demand growth although it will take a number of years while the stock of oil-consuming appliances (vehicles in particular) responds.
The result of these market feedback loops is a situation that will rapidly become unsustainable. Higher supply and lower demand will put the high prices needed by OPEC for political survival under serious pressure.
The current situation is very reminiscent of the 1981-86 period which culminated in the dramatic 1986 oil price collapse. The similarities are compelling. Saudi Arabia then was acting as the so-called swing producer in order to defend high prices. As demand fell following the oil shocks of the 1970s and non-OPEC supply began to rise, Saudi Arabia found itself absorbing the quota-busting of other OPEC members in a market where the demand for OPEC crude was falling. Saudi Arabia's eventual rejection of that role in 1985 in the face of rapidly falling oil revenues triggered the 1986 price collapse.
In the last nine months, Saudi Arabia appears to have quietly resumed that swing role trying to keep the price of the OPEC basket crude around $100/B. This has been done by changing production levels outside of any formal changes within OPEC.
Furthermore, the 1981-86 period was preceded by the existence of new potential oil provinces. Thus, the North Sea, Alaska and other non-OPEC resources were lurking in the background waiting to add to global supply but requiring higher prices given their significantly higher production costs. Today it is the unconventional oil resources potentially unlocked by shale technology that lurk, also requiring higher prices to encourage investment in developing capacity.
Finally, in the 1981-86 period, the industry consensus as expressed in the IEA's 1977 World Energy Outlook expected ever-rising OECD oil demand. Such views ignored, or at least under-estimated, the impact of the oil price shocks of the 1970s on consumer behaviour. In particular, it neglected the fact that oil was being pushed out from use as a power generation fuel. Today, as already described, there is a similar consensus revolving around the MICs that again ignores the fact that oil prices have steadily been increasing, albeit around a volatile trend since 2002. Coupled with subsidy reform in the MICs this will begin to create significant demand destruction.
Thus market responses will impact prices as they did in 1986, possibly leading to a significant price collapse. In this context, it is as well to remember the vulnerability of oil prices as illustrated by the experience of 2008. On 3 July 2008, WTI reached a peak of $147/B: eight months later in February 2009 the price averaged $39/B.
How long will Saudi take the pain?
As with 1981-86, the key now will be how long Saudi Arabia continues to absorb the lower call on OPEC (and the inevitable OPEC cheating) before the pain becomes too great. This is at a time when many OPEC countries are announcing grand plans to expand their crude producing capacity.
Outside of Saudi Arabia, OPEC members are expected to add some 5mn b/d to liquids capacity between 2012 and 2016. While in recent years Saudi Arabia has been able to accumulate a financial cushion – although exactly how much is uncertain – cushions eventually disappear. Given the continued growth in population, the ever-increasing entry of young Saudi nationals into a job market that has little interest in them, and the growing popular expectations regarding the provision of jobs and services, this could come sooner than many expect.
When Saudi Arabia is no longer willing or able to protect prices then prices must fall. The ability of OPEC to manage such an eventuality collectively and effectively must be in doubt. Divisions have always characterized the organization. These range from divisions arising from the relative size of reserves and the consequent time frame over prices to divisions over attitudes towards the US. Now OPEC is potentially facing extra sectarian divisions following the invasion of Iraq in 2003 with signs of a growing rift between Sunni and Shi'a.
In the past, price collapses such as 1986 and 1998 were relatively short lived because Saudi Arabia was able to come to a workable agreement with Iran that effectively rescued the oil price. Given divisions over how to manage the civil war in Syria, this route to rescue oil prices must be in doubt.
However, there are differences between today and the 1981-86 period that complicate the story. Then there were no 'paper' markets trading future barrels of oil although there was the beginning of the development of forward markets for North Sea crude. NYMEX did not start trading paper barrels in any significant quantities until after the 1986 price collapse. Today futures markets play a major role in influencing price determination. Furthermore they can lead to prices changing at a much faster rate than before. Thus the sorts of price changes which took weeks in the 1981-86 period can happen now within a few hours.
Another difference concerns the fact that new unconventional oil supplies today have a very different structure of production costs. They have much higher relative variable costs. Thus following the 1986 oil price collapse, the economists' 'bygones rule' meant loss-making fields continued to produce so long as they covered their variable costs and made some contribution to fixed costs. Higher variable costs will mean fields will be shut-in much sooner and supplies will respond much faster to lower prices than was the case post-1986.
In a similar vein there are changes that will affect the demand response. In 1986, only in the OECD did lower crude prices not necessarily translate into lower product prices because of the sales tax wedge imposed by the OECD governments. Lower crude prices simply allowed those governments to increase their sales tax take and so OECD oil demand was very slow to increase. Today, as discussed earlier, more governments outside the OECD are realizing the joys of taxing oil products so lower crude prices will be slow to convert into higher demand.
Could low prices lead to a second 'Arab spring'?
If oil prices do collapse, the resulting lower oil revenues may mean governments in the Middle East and North Africa lack the funds to contain popular unrest. This could lead to further political discord in the oil producers. After all, recent events in Egypt are in part driven by the failure of the Muhammad Mursi government to deliver anything in terms of improved economic conditions. An Arab Uprising Part II, especially if it spilled into the GCC countries, would certainly spook the markets into creating a significant geopolitical premium as happened in 2011 during the Arab Uprisings Part I. This would push crude prices higher, possibly aggravated by a significant supply response if the unconventional boom in the US faltered as the result of the initial price collapse. The result will be very much greater crude oil price volatility moving forwards.
The policy implications of such volatility will be profound. For oil consumers, security of supply concerns in the past were based largely on fears of physical disruption, hence the US obsession with 'Energy Independence'. Thus domestic supplies were (quite wrongly) assumed to be free from threats of disruption.
In a world of greater price volatility, such supply concerns would be overtaken by those based on the macro-economic impact of oil price volatility. This was a concern that began to emerge in the price volatility of 2008, before the financial collapse post-Lehman Brothers moved other issues up the global agenda. At the very least such concerns would increase pressure on governments to further regulate the paper markets.
For oil producers such oil price, revenue and foreign exchange volatility would present serious challenges. It would bring to the very top of the agenda the need to diversify their economies away from oil dependence. This has long been an aim since the first oil shock of 1973 but for the most part with very disappointing results.
According to an IMF report on the GCC in 2011, the contribution of non-hydrocarbon GDP to total GDP was 61% in 1990. By 2010 it had fallen to 51%. As for the non-hydrocarbon primary fiscal deficit – an excellent proxy measure for dependence – for Saudi Arabia this rose steadily from an average below 50% in the 1990s to 140% by 2010. Other GCC countries showed a similar trend. These disappointing results, reflecting a failure to diversify the oil-based economies of the region, will feed the consequent political upheavals arising from lower oil revenues.
Rough ride ahead
Taken together, this analysis suggests that international oil markets are in for a very rough ride. Furthermore, it is difficult to see how the negative consequences of price and revenue volatility can be mitigated. Use of the paper markets to hedge, apart from raising important theological issues for some producers, is more likely to add to price volatility. Use of stabilization funds has had a poor record and has tended to act as a magnet for poor governance.
All in all, the prospects for international oil markets are extremely uncertain. This will inevitably inhibit future investment plans in the industry. In an industry with such long project lead times, this could carry serious implications for supply 10 or so years down the road which potentially adds further to volatility.
This article originally appeared on the Middle East Economic Survey (MEES). A shorter version was published in the Financial Times on 25 July 2013.