Politics and Economics of the Oil Market
In recent months markets have witnessed a more noticeable decline in oil prices, mainly due to a combination of oversupply and the weakening demand growth. On the production side, oil supply to global markets is at all-time high. The United States alone produces the highest level in three decades — approximately 9 million barrels a day. And Libya, which has been recovering in recent months — has been adding over a million barrels a day to the global supply. Oil demand that was once expected to see growth in countries like China, Russia and India have not met such growth expectations. Therefore, these two factors; oversupply with weakening demand growth — resulted in big fall in prices since June.
Historically OPEC, which views its role in the global oil market as a balancer — has acted in a way to try to balance the oil market. But in recent months some of the big heavyweights in OPEC — seem more interested in defending their own markets than cutting productions to put a hold on the falling prices. Traditionally, OPEC has agreed to cut supply but it is far from certain whether they will be able to do that now as next OPEC meeting in Vienna is underway on November 27th. The meeting will be very closely watched to see whether the members will agree to take some supply off the market to try to balance it again or whether there is going to be no agreement, which could lead to fall in prices even further.
The current environment if continued will pose a serious challenge for countries that depend heavily on oil to meet their budget requirements since many of them have implicitly high break-even numbers. For instance, Russia and Iraq are faced particularly with difficult circumstances also partially because of broader geopolitical tensions that exist. Russia — already squeezed by inflation and a drastic decline in its currency, has found its ability to borrow money severely curbed by the recent sanctions and its budget could fall into deficit next year if prices were to stay in the range the are in now. Iraq is facing a costly and potentially open-ended, military conflict against the Islamic State. The government in Baghdad is faced with skyrocketing public expenditure requirements, large public payroll, food and energy subsides as well as a ramshackled armed forces. Some other oil producing countries are also experiencing substantially more budgetary pain from the decline in prices. Venezuela, because of economic problems — with limited options in responding to the price decline, is forced to leave less money for social spending, government payrolls and subsidized imports of vital goods. Nigeria, facing political uncertainty as preparing for its presidential election next year and falling oil prices is changing the political calculus.
In the world of politics some are suggesting, that there might be a global oil war underway with the United States and Saudi Arabia on one side against Russian and Iran on the other. Regardless of the dynamics of these alliances — coincidentally or intentionally — the net result has been to make life difficult for Russia and Iran at a time when the United States and Saudi Arabia are confronting both of them in a proxy war in Syria. But neither Moscow nor Tehran will collapse tomorrow in this oil war. And if prices fall below $70 will see a drop in U.S. production, as some exploration wont be cost effective and therefore prices could certainly firm up. It is undoubtedly clear that price falloff serves US and Saudi strategic interests and it harms Russia and Iran. But in the near term, these big producers will probably face budget problems in varying degrees of severity, with an array of economic, strategic and political aftermaths. It is also likely that Saudi Arabia may allow lower prices to continue, in part to squeeze its main rivals — Iran and Russia — and in part to put pressure on shale oil producers in the United States, whose higher production costs make it harder for them to compete when prices are lower abroad. It is no secret that Saudi’s relatively low production cost and its domestic spending program allow for a balanced budget a price of roughly $95 a barrel, compared with $100 or more for Russia and even more for Iran. Saudi Arabia also has huge cash reserves to prop up its budget while prices remain low. The real question for Saudi Kingdom is how much are they willing to eat into their cash reserves and for how long until they adjust production down.
In the case of Iran, the current descend in oil prices is not likely to drive the country to strike a nuclear deal with the West by Nov 24th deadline. It might push Iran into greater compromise if the talks are extended and the low prices persist. It should be recognized that Iran has become more resilience to the oil prices — having one of the highest fiscal break-even price of all the oil exporting countries, the country has suffered from ‘under-priced’ oil for a while, and that hasn’t had a substantial impact on their behavior. Therefore, it could be argued that oil prices are pretty far down the list of things that affect Iran’s calculation at the negotiating table on its nuclear program. Another reason, for Iran’s resilience is that the country does not actually feel much of the day-to-day storm of the markets because the sanctions require that most of its oil revenue accumulate in escrow accounts outside the country and used for bilateral trades.
Thus far, economic and political factors have added up to a very sloppy oil market — where has been driving prices lower. Normally, falling oil prices would boost global growth. One thing is certain, that the global economy is certainly weak today. Surely, global demand for oil is likely to increase again once the global economy picks up. But even an increase in demand might not drive up prices substantially if new production sources like shale oil, along with more fuel efficient technologies in industrialized countries, maintain an overabundance of oil on the market.