The US debt default, the Arab Spring and the global slowdown spell the most uncertain fate for crude in history
No sooner had warnings surfaced about the price of oil reaching unsafe levels this summer than the global economy started panicking about crude hitting the lows seen in 2008.
The volte-face, sparked by a downgrade of US debt and a string of gloomy economic forecasts, has left Gulf governments drawing parallels with the fallout from the credit crisis, which severely damaged their petro-dollar income. In 2008, oil plummeted from a high of $147 a barrel to $36, fuelling the worst recession in history. Analysts are asking whether an oil-induced double-dip recession is now on the cards.
Key energy exporters Saudi Arabia and the UAE need oil prices above $85 a barrel to meet their spending obligations, according to the latest estimates. These concerns seem a far cry from fears expressed in the first half of 2011 about a fresh oil price spike and its effect on the world's financial health.
Few would disagree that the S&P downgrade of US debt to AA-plus in August was a game-changer for GCC oil exporting nations. The Organisation of the Petroleum Exporting Countries (Opec) and the International Energy Agency (IEA) have since trimmed crude demand for 2011, while also decreasing next year's growth prediction.
Given this, if the past is any guide to the future, analysts say sustained high oil prices for the remainder of the year will trigger a serious slowdown in the fragile global economy.
This scenario emerged in 2008, but also twice before, first in the oil shock of 1973/74 after the Arab-Israeli conflict choked oil flows; and again during the 1979 Iranian revolution and subsequent Iran-Iraq war. Worryingly, in each of these cases the cost of oil relative to global economic output has hit current levels.
PRICES HIGH
With a slump seemingly around the corner, Gulf states will be looking at factors that could support prices.
In the first instance they are not expected to allow prices to plummet, so they may reduce oil output sooner than they did after the financial crisis in 2008. This could, of course, send world economic growth into freefall, shattering their main income and any hopes of breaking even on their budgets and paying for the planned infrastructure spend.
The loss of production due to the Arab Spring chaos this year and demand from emerging economies like China are two powerful narratives that could provide a floor for prices.
Robeco, a Dutch asset management firm, said recently that China's unquenchable thirst for natural resources and demand from developing markets continues to outpace new sources of supply, leading to escalating oil prices. A natural resources fund manager with the firm, Peter Csoregh, said that tensions were likely to erupt as China vies with the West for natural resources to support its growth rate as the government tries to stave off social unrest. "Can China double from here, can they triple from here? Sure they can. Is there enough oil or copper in the world to allow them to do that? No," he told Reuters.
All the risk factors that could spur the oil price again are lurking in the background, say analysts. Disruption to production in volatile areas including Libya, Iraq, Nigeria and Syria pose perhaps the most immediate threat to supply. And if the so-called 'killer of production', US arch enemy Venezuelan President Hugo Chavez, regains his health in the long-term this will likely provide further support for high oil.
Simon Wardell, an oil analyst at the economic forecasting firm IHS Global Insight, said: "The biggest concern is the things you can't predict, and we've already seen that this year with developments in the Middle East. Unforeseen events like these could have a huge impact.
Meanwhile, academics at Stanford University in the US that study the causes of previous price rises, in July singled out speculation among oil traders as a big factor. In a paper entitled "Investor Flows and the 2008 Boom/Bust in Oil Prices", Professor Kenneth Singleton - a highly respected econometrician - mounted a wide-ranging assault on the belief among policymakers that speculation does not affect commodity prices. Singleton argued that in their attempt to outplay competitors, traders stoke the market and push prices higher. His conclusions undermine the long-held view that future prices are determined solely by economic fundamentals.
Charles Maxwell, a senior energy analyst at brokerage firm Weeden & Co, said speculators like hedge funds should only be blamed to a point. "After oil reached $147 a number of institutions examined the role of speculators in the rise and came to the conclusion that it was players like hedge funds driving it to its highest point. But the facts don't bear that out. We now know all about the contracts hedge funds were involved with; and the physical holding of oil from $120 upwards was diminishing all the time. So hedge funds were not responsible. In general, speculators got hurt last time so they are unlikely to be as carefree this time round."
NEW DANGERS
The Middle East faces a more explosive set of challenges in 2011 than it did three years ago, with the potential for revolutions to spread throughout the region and a greater dependence on economies around the world as a result of increased globalisation.
"Geopolitics is much worse this time round," said Richard Swann, managing editor for Europe, Africa and Middle East at energy analyst firm Platts, who added that organisations like Opec and IEA are diminishing forces in the future price of oil. In June, the IEA announced it would release 60 million barrels of oil from its member governments' reserves, apparently in response to "ongoing disruption of oil supplies from Libya". But any attempt to reduce prices in the medium- or long-term failed, as the price of Brent crude fell $5 on the announcement but rallied since.
Today, following August's economic developments, Opec faces the exact opposite dilemma of keeping prices buoyant. It can cut output to boost prices, but reports last month suggested that the cartel was not planning to get together before the next scheduled meeting in December.
Opec, provider of about 40 per cent of the world's crude, set its biggest-ever supply cuts in late 2008 amid a collapse in global demand. The decision capped production at 24.845 million barrels a day for all members except Iraq, which is exempt from the quota system. Members have largely exceeded quotas in 2011 as they sought to take advantage of higher global crude prices earlier this year and to make up for the lack of Libyan crude due to the civil war in the country.
Abhay Bhargava, an energy and power systems specialist at Frost & Sullivan International, said Gulf governments that are looking to support higher oil prices for budgetary purposes could be playing a dangerous game as elevated prices could suffocate foreign investment into the Gulf from oil consuming nations.
"Gulf countries are dependent on other economies around the world, as much as they like to think they're not. If you get a price at $147 then Gulf governments will have a lot more money to spend and build up their economies. But at this price it's not sustainable and is rather impractical. Other consuming nations will suffer and the GCC will eventually be on the receiving end," said Bhargava.
Unforeseen issues that could push oil prices higher, such as a new wave of unrest in the Middle East and a repetition of an event like BP's oil spill last year in the Gulf of Mexico, are by their very nature hard to forecast. Yet, expected weak economic growth in the coming years has led many to believe that the current global conditions seem unlikely to support any immediate flare-ups in crude. Amid this uncertainty, governments in the Gulf will be treading carefully from now on
Past oil shocks and economic slumps
In 1973/74, during the first global 'oil shock', oil prices rocketed after an Arab oil embargo in response to an Arab-Israeli war disrupted oil flows and triggered panic buying.
In 1979, revolution in Iran knocked out much of the country's oil output and was followed by a long Iran-Iraq war, bringing a second oil shock.
In 2008, propelled by a housing bubble, speculative buying of new debt instruments and a commodities boom, oil prices exceeded $100 per barrel for the first time and soared to a record high above $147, helping trigger the financial crisis and the worst slump since World War II.
Saudi's troubles lay ahead
Even when oil prices strengthened to $100 a barrel in the summer and showed little sign of falling, the Saudi Arabian economy was in peril, according to a report by Riyadh-based Jadwa Investment.
The kingdom faced a "difficult energy and revenue future" because it remained over dependent on high oil prices to cover massive expenditure, on average a seven per cent growth per year.
Only "sustained sharp rises in oil prices" would be enough to meet fiscal needs, the study concluded. This now seems unlikely as dark clouds over the global economy are already pushing prices lower.
Jadwa Investment said one of the other main causes for concern was that Saudi's domestic consumption of oil (and gas) is rising very sharply, reducing the amount of oil available for export. It may be time for the Arab world's largest economy to adjust spending.
Spare a thought for US and UK drivers
As summer approached motorists in the West were saddled with rising fuel costs, but most will now be breathing a deep sigh of relief.
Prices at the pump are set to fall after climbing since 2010. Crude prices remained in the $70-80 range last year but surged to more than $127 a barrel in April. Overall, in the year to July prices rose 35 per cent to steady around $100.
Oil importing nations in the West often find their consumers at the sharp end of oil price rises, whether it's a more expensive car journey or steeper airline tickets because of surcharges.
Although in the UK it costs comparatively more for petrol than in the US, this can be put down largely to the different tax regimes, which see the UK consumer worse off. But in times of rapidly rising oil prices, the US will struggle without this tax buffer and will see larger fluctuations in prices at the pump.
With prices in July poised to rise to 2008 levels, there was a big chance of a fierce backlash from the American consumer, as cheap fuel is often regarded as a basic necessity in society. Therefore, consumer behaviour is pegged to oil prices to a greater extent in the US than other nations. The US downgrade and weakened outlook for oil prices will have gone a long way to relieve pressure around this issue.
© Gulf Business 2011
