When oil prices fall, canny politicians get going

Pinak Ranjan Chakravarty

At their meeting in Vienna on November 27 last year, the 12-member Organization of the Petroleum Exporting Countries, the cartel of oil-exporting countries, decided to desist from cutting production in the face of the dramatic fall in oil prices, leaving observers stunned. Last year, oil prices had plunged 30 per cent from $115 per barrel in June to around $80-82 in November. After the OPEC decision, oil prices declined further to around $72 a barrel. The price slide has continued and is currently hovering around $60 a barrel and may even fall further. The fall has been caused by a demand-supply mismatch, with the global market awash with American shale oil and increased supplies fromIraqand Libya. For the first time oil production in the United States of America has rivalled that of Saudi Arabia. Clearly, the oil market was being oversupplied. Yet OPEC decided not to cut production, leaving companies in the energy, mining and financial sectors nervous. Lower oil prices have hit revenues of countries like Russia, Iran, Nigeria and Venezuela. Saudi Arabia's decision not to cut production was the initial trigger for the price slide. The various stimulus measures put in place after the 2008 global economic crisis are tapering off, adding to fears of stagnation in the global economy and lower demand for oil.

The Russian rouble has already fallen over 14 per cent since July 2014 against the dollar and is falling further. Russia's economy is underpinned by oil to the extent of 60 per cent of its export earnings. This, coming on top of the sanctions imposed by the West on Russia on account of developments in Crimea and Ukraine, has squeezed Russia's access to global financial markets, resulting in a severe downturn in investment flows. But Russia is not broke; it holds at least $455 billion in reserves.

Currencies of key BRICS members have also fallen: 7.8 per cent for the Brazilian real, 1.6 per cent for the Indian rupee. The growth in the Chinese economy over the past six years has helped the global economy, largely because of the stimulus package initiated by the Chinese government and the massive expansion of credit. But the Chinese economy is in the grip of a deflationary trend. A Chinese government report estimates wasteful spending of the order of $6.8 trillion since 2009 on "ineffective investment". The Eurozone economy has not recovered and economic output remains at the same level as 2007, with inflation still falling six years after the global financial crisis. "Abenomics" has not been able to save Japan from entering another recessionary period, its fourth in the last six years. In the world's third largest economy, public debt is now 250 per cent of its gross domestic product and Japan's credit rating has been reviewed. But Shinzo Abe has roared back to power in the recently concluded general election in Japan and hopes of revival of the Japanese economy look better.

As for OPEC countries, the largest oil producer, Saudi Arabia, depends almost 90 per cent on oil sales for its government revenues, although it can withstand lower oil prices for a longer period. High oil prices have helped the countries of the Gulf Cooperation Council accumulate current reserves of $2.4 trillion after revenues doubled from $317 billion in 2008 to $729 billion in 2013. These will allow the GCC economies to sustain low oil prices for a year or two. Thereafter, pressure will build up, stemming from the need to raise government revenue to fund infrastructure, energy, industrial development and the bloated welfare obligations of the GCC countries that have act as a firewall to isolate their citizens from the virus of the so-called Arab Spring.

Other OPEC countries face a more difficult dilemma. OPEC accounts for 40 per cent of global oil production. Hence production cuts can stabilize prices, if they adhere to their own production limits. But OPEC members are notorious for exceeding their production quotas. Saudi Arabia is known as the "swing producer" since it can reduce or ramp up oil production to regulate prices. But it has shied away from its role as a "swing producer" and seems more concerned on retaining its market share by offering discounts to its regular buyers.

While American financial markets appear to have been only marginally affected by the OPEC decision, falling oil prices will have major long-term consequences. The projection of OPEC for oil production in 2015 is at 28.9 million barrels, a 12-year low. The sharp decline in oil prices may put medium and small exploration and production companies in the US under pressure. If the fall continues, these companies could go out of business and land their direct lenders and holders of shale oil bonds in trouble.

Shale oil production became profitable when oil prices reached around $100 per barrel in 2011, when extraction costs were between $60 and $70 per barrel. Shale oil extraction is very capital intensive, unlike more traditional methods of oil production, where physical capital has a relatively long life. This sector depends on the flow of funds from financial markets. The shale oil boom in the US has made it the world's largest producer of oil and helped revive the US economy, creating employment and keeping unemployment down. The downward spiral in oil prices will force US companies out of business and Saudi Arabia will retain its market share of the global oil market. The last time oil prices tumbled more than $40 within six months was in 2008, the same year as the financial crisis. Will it happen again? It is too early to tell.

Several theories are being circulated to explain the rapid fall in oil prices. The most popular one holds Saudi Arabia responsible for deliberately pumping more oil to keep the price down to make shale oil less profitable and eliminate or retard competition. Shale oil production is crucially dependent on oil prices remaining in the range of $80-90 per barrel. Analysts have pointed out that over one trillion dollars have been invested in shale oil production based on oil prices remaining around $95 a barrel to remain economically viable. American energy companies producing shale oil fear that low crude prices will force some of them to stop drilling. They are now eager to circumvent the ban on the international sale of US-origin oil and gain access to new markets. Refiners and other buyers of light oil across Asia are interested in American condensate so they can diversify their supply from West Asia. Low prices may retard US shale oil production in the medium-term. Saudi Arabia cannot be held to account on this count alone. Shale oil supplies have stabilized world markets when many oil-producing countries are in turmoil and oil supplies have reduced from them.

Saudi Arabia comprises too simplistic a reason. Geo-politics and the strategic goals of the US and the regional ambitions of Saudi Arabia are also at play. While squeezing shale oil producers puts Saudi Arabia and US on opposite sides, geo-strategic objectives put the two countries on the same page. It is widely believed that the common strategic goal is to weaken Russia and Iran. The US and Saudi Arabia agreed during the September visit of the US secretary of state to Saudi Arabia that the kingdom will not only maintain production levels but also undercut global prices by offering large discounts to its major buyers in Asia. That alone can explain the drop in oil prices. Russia and Iran are the two economies that are under attack, as this strategy seeks to batter these economies and force them to accept US-Saudi terms in Syria, that is, the ouster of the Bashar al-Assad regime, the rollback of Iran's nuclear programme, Russia's pushback from Ukraine and further American plans to bring the central Asian States into the Western sphere of influence by enlarging the North Atlantic Treaty Organization. In an April 2013 speech, Tom Donilon, then Barack Obama's national security adviser, said: "America's new energy posture allows us to engage from a position of greater strength. Increasing US energy supplies acts as a cushion that helps reduce our vulnerability to global supply disruptions and price shocks. It also affords us a stronger hand in pursuing and implementing our internationalsecurity goals."

Similar US-Saudi strategies in the past led to flooding the global market with oil in 1986, sending oil price down to below $10 a barrel, destroying the economy of Saddam Hussein's Iraq, then a Soviet ally. Ultimately, it also weakened the Soviet economy to such an extent that the Soviet Union broke up and the US became the victor in the Cold War. It is clear that the objective of the current strategy of driving down the price of oil is to ensure a collapse of Russian and Iranian oil revenues and bring both countries to their knees, ultimately bringing down the Vladimir Putin government in Russia.

Russia meanwhile has not been sitting idle. It has made a strategic pivot towards China, to put its eggs in other baskets and reduce its dependence on the West. A high-powered Chinese delegation, led by Li Keqiang, has signed a slew of deals in Moscow on energy, finance, satellite navigation and high-speed rail. Russia-China trade this year could reach $100 billion, approximately a 10 per cent growth compared to last year.The Russia-China strategic partnership has been improving since the path-breaking $400 billion, 30-year gas deal, the largest this century, in May 2014.

Russia is progressively lifting restrictions and opening up to Chinese investments and China is eagerly gobbling up Russian raw materials and accessing advanced technology and weapon systems. China will get the S-400 missile systems and Su-35 fighter jets in the first quarter of 2015. China will also acquire the Amur 1650, Russia's brand new submarine, as well as components for nuclear-powered satellites in due course. This is not good news for India.

At the Shanghai Cooperation Organization summit in Dushanbe, Putin referred to the the"great potential"of a"common SCO transport system" linking "Russia's Trans-Siberian railway and the Baikal-Amur mainline"with the Chinese Silk Roads, thus "benefiting all countries in Eurasia". A new synergy is being developed with the Chinese promoted New Silk Roads with an upgraded Trans-Siberian railway. The central banks of China and Russia havesigned a three-year, 150-billion-yuan bilateral local-currency swap deal. This deal bypasses the US dollar and also explains Washington's discomfort and its current proxy economic war against Moscow, based on lowering oil prices.

The demand for natural gas, regarded as clean energy, is growing rapidly. The world's largest known natural gas reserves are in the Persian Gulf, mostly in the territorial waters of Qatar and some in Iran. China's State-owned China National Offshore Oil Corporation signed an agreement with Iran in 2006 to develop the Iranian North Pars gas structure and build liquefied natural gas terminals to transport gas to China. The Qatar side of the Persian Gulf, called North Field, contains the world's third largest known natural gas reserves behind Russia and Iran. Qatar is the world's largest exporter of LNG, with Asia its largest market. Qatar also covets the European Union market that Iran, Russia and Syria also want to access. Russia is already the largest supplier of gas to the EU. In 2009 Qatar had proposed to Syria a plan for a gas pipeline stretching from Qatar's north Field via Syria and Turkey to the EU. The president of Syria, Bashar al-Assad, declined the offer in view of Syria's long and friendly relations with Russia and Gazprom, the Russian gas behemoth. The Iran-Iraq-Syria gas pipeline agreement of 2011 was a 'red rag' to the Saudi-Qatar 'bull' and the conspiracy to oust Assad was set in motion, with the US and Turkey also pitching in to ignite the Syrian civil war that has taken upwards of 200,000 lives.

Lower oil prices have helped major energy importers like China, Japan and India. The number of supertankers sailing toChina has risen to an all-time high according to ship-tracking data. TheInternational Energy Agency, a Paris-based advisory body comprising 29 countries, has reported that China is probably adding to its strategic crude oil stockpile. China is soaking up the global oil glut and it would seem logical that India too is stockpiling. India's stockpiling plan began in 2003 and by 2013 its stockpiling capacity would have reached 5.4 million tonnes of crude oil. Additional capacity is being added to raise stockpiling capacity to 12.5 million tonnes. While the geo-politics of oil pricing pits the US-Saudi-Qatar and other allies against Russia and Iran, large importers of oil like China, Japan, India and South Korea are enjoying a period of low oil prices. For these economies, lower oil prices mean large savings in imports.

What happens in this geo-political global chessboard with oil pricing as the main economic tool will depend on who blinks first - US shale oil companies, OPEC or Russia. For Russia, lower oil prices will mean less public spending as revenues plummet. Russia has a cushion of around $450 billion in reserves, and the fall in the value of the rouble against the dollar helps in balancing the budget and reducing the deficit. The economy, however, will slow down and may head towards stagflation. China has pledged support to Russia as it faces Western sanctions and the drop in oil prices. Increasing trade in yuan is an option. The Chinese foreign minister, Wang Yi, has been reported to have said: "Russia has the capability and the wisdom to overcome the existing hardship in the economic situation... If the Russian side needs it, we will provide necessary assistance within our capacity." China overtook Germany as Russia's top trading partner in 2011 and is firmly entrenching itself in the Russian economy.

Will OPEC continue to remain cohesive? This is a moot question since OPEC members have consistently breached production quotas. The November decision to maintain production levels will encourage overproduction, since most oil exporting countries need more revenue to balance their budgets. The US shale oil companies may see restructuring as smaller companies sell out and quit the shale oil sector. The US may also dilute its 40-year-old ban on exporting unrefined US crude oil. Senators and Congresspersons are already lobbying to change this law and permit higher US oil exports. The lower oil price is likely to stimulate markets. The IEA forecast has the global oil demand rising from around 700,000 barrels a day to 900,000 barrels a day in 2015 and US companies want an increasing share of this market. The Saudi oil minister has asserted that the kingdom will not reduce production because it does not want to lose market share.

India will certainly reap the benefit of cheaper oil prices. Imports will cost less, adding to the reserves. Cheaper oil will help control inflation, lower interest rates and encourage investment. Subsidies can be cut back reducing pressure on the growing budget deficit. This favourable window will not last for long, at best till end-2015. The latest economic indicators from the US show American GDP growing at over 5 per cent, reinforcing faith that the global economic recovery cycle has begun and oil prices may start climbing again.

The author is former secretary in the ministry of external affairs and is currently a Distinguished Fellow at the Observer Research Foundation, Delhi