Gulf stability and the oil supply scenario

Talmiz Ahmad

November 17, 2014

Given that oil has been central to West Asian affairs, it is not surprising that oil-related developments should be examined in terms of their economic and political implications in the fraught environment that prevails in the region

West Asia has dominated world headlines over the last few years due to the eruptions related to the Arab Spring, conflicts in Iraq and Syria, and, more recently, by the challenges posed by the “Islamic State” to regional state order. Now, over the last few weeks, a new source of uncertainty has emerged: the dramatic fall in oil prices. Given that oil has been central to West Asian affairs as the bedrock of domestic politics and the source of regional competitions and external interventions, it is not surprising that these oil-related developments should be scrutinised in terms of their economic and political implications in the fraught environment that prevails in the region.

The plunge in oil prices has been so swift and unexpected that most observers have been caught by surprise. In mid-June, oil prices were about $115 per barrel, having been over $110 for the previous year and over $100 for the last three years. They fell to $102 in August and to $98 in September. In October, prices plunged to below $85 per barrel, while in early November they were at $80, the lowest level in four years, having fallen 30 per cent since June.Demand-supply mismatch

With every decline, there were expectations that Saudi Arabia would play its traditional role as “swing producer” and cut production; but this failed to happen. This was surprising since almost all major oil producers have become dependent on high prices, with break-even levels usually over $90 per barrel to meet their ever-increasing fiscal obligations. The main explanation for this situation is that world markets are flush with supplies for which there are not enough consumers. The global economic slowdown is the principal culprit: with China’s national growth projected at around seven per cent per year, increase in oil demand is negligible. Europe is also not expected to contribute to increased demand due to its sluggish growth.

The supply scenario is quite different. Not only have the Organization of the Petroleum Exporting Countries (OPEC) members not effected cuts in their production, additional production has also come into the market from member-states experiencing domestic turmoil — Libya and Iraq — which have had record exports. But, the biggest market changer is shale oil production in the United States: with additional production of 3.9 million barrels a day (mbd), the U.S. now produces more than all OPEC members except Saudi Arabia. The International Energy Agency (IEA) thinks low prices will continue next year due to low demand and high shale oil production and believes we now have “a new chapter in the history of oil markets.” Goldman Sachs has forecast prices of $85 for early next year, while J.P. Morgan predicts prices at between $80-95 over the next two years.Grand strategy scenarios

The unexpected fall in prices has triggered two competing “grand strategy” scenarios. One scenario emerges from the impact of the price falls on the economies of U.S. adversaries, Russia and Iran. The columnist Thomas Friedman sounded triumphalist when, in mid-October, he said he was seeing a “global oil war” which had the U.S. and Saudi Arabia arrayed against Russia and Iran. The latter are crucially dependent on oil revenues and will be seriously affected by low prices. It is the fond hope of the proponents of this scenario that the economic pressures generated by low prices would make them more accommodative in their engagements with western interlocutors.

However, whatever the neo-cold warriors in Washington may hope for, both Russia and Iran are known to be resilient and unlikely to compromise their established foreign policy positions only on account of falling oil prices. In fact, the adverse circumstances are likely to encourage domestic tenacity and greater camaraderie between the two beleaguered nations.

The other scenario sees a deliberate Saudi attempt to retard the further development of the shale oil industry in the U.S., which is crucially dependent on high oil prices of $80-90 per barrel to sustain production. Oil analyst Edward McAllister has asserted that Saudi Arabia has “started a global price war aimed at quickly denting U.S. oil output.” Analysts have pointed out that oil firms have committed investments of over a trillion dollars in projects based on oil prices at $95 for them to be viable.

However, while low prices may put medium-term U.S. production in jeopardy, this is hardly a deliberate Saudi ploy. The Kingdom is well aware that shale oil has in fact stabilised world markets at a time of acute turmoil in oil-producing countries. For this reason it has repeatedly welcomed new production sources, particularly since unconventional production boosts the demand for fossil fuels and reduces investments in renewables.

Beyond the grand strategies put forward to explain the present scenario, the simplest explanation is perhaps the most plausible: like most observers, Saudi Arabia was surprised by the dramatic fall in prices. It realised that the fall was not a short-term seasonal blip but one that emerged from changing market fundamentals. What it was not willing to do was to assume full responsibility for corrective action, believing that this should be the collective responsibility of OPEC as a whole. It feels the best way of bringing other members on board is to let prices fall until the meeting of OPEC oil ministers in Vienna on November 27, by which time the member countries would be more amenable to participate in collective action. In the meantime, the Kingdom has focussed on retaining its market share in spite of the prevailing low prices.Economic and political challenges

The decline in prices has serious economic and political implications for producer countries experiencing domestic turmoil, such as Iraq, Libya and Yemen. They are today entirely dependent on oil revenues to maintain security and meet the welfare requirements of their restive populations. The Gulf Cooperation Council (GCC) producers may not at present feel any need to intervene in the market since they have a current account surplus of $2.4 trillion and substantial reserves to handle fiscal shortfalls in the short term. However, even they will not be able to accommodate a sustained decline in prices as they need to fund infrastructure development, diversify their economies and, above all, meet their ever-increasing social obligations promised to their communities to keep the Arab Spring at bay. They also need to urgently address long-standing energy issues such as burgeoning and wasteful domestic consumption and massive subsidies, estimated at $160 billion annually.

There are longer term concerns as well. Analysts project a global oil requirement of 104 mbd in 2040, as against the present demand of 90 mbd. This additional demand will be met by unconventional production, i.e., shale oil from U.S. and other sources, oil sands from Canada, deep water oil from Brazil, and from the environmentally sensitive Arctic region, where cost of production will be over $90 per barrel. At the same time, with declines in U.S. shale oil production from the 2020s, global dependence on conventional supplies will become crucial. Thus, the Gulf, with 25 per cent global production and 30 per cent of global reserves, will remain at the heart of the world’s energy security interests.

Gulf supplies could be jeopardised by various factors, such as: political turbulence in Iraq; constraints on supplies from Iran, and the failure of the region to make the required investments in new exploration and development due to low prices. Analysts estimate that investments of $900 billion are required annually to meet the world’s long-term demand. The situation could be further aggravated by political uncertainty in the GCC countries due to their continued confrontation with Iran, the sectarian divide, and the threat from extremist elements, all of which have found expression in the fratricidal conflicts in Syria and Iraq.

This has serious implications for Asia. Today, 60 per cent of Gulf production is consumed in Asia; by 2035, the Gulf will export 90 per cent of its oil to Asia, while meeting about 90 per cent of Asia’s needs. Gulf stability is thus a matter of abiding interest to Asian consumers. In this scenario of contention and conflict, the challenge before the principal Asian consumers, led by India, China, Japan and Korea, is to work together to shape a new regional security paradigm that is inclusive and provides a dialogue and confidence-building platform that the contending Gulf countries desperately need. This is obviously an unprecedented and daunting task, but the gauntlet will have to be picked up; otherwise there will be no Asian growth, no Asian Silk Road, and no Asian Century.

(Talmiz Ahmad is a former diplomat.)

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