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Will oil prices continue to decrease?

October 23, 2014 17:31 IST

Pushing a barrel of oil back to around $100 would require a reduction of production of about two million barrels a day - a cut that would fall predominantly on Saudi Arabia, says Claude Smadja.

It has taken just a few weeks for oil prices to drop by close to 25 per cent, sending shockwaves around the world and raising as many economic questions for the future, as well as geopolitical and strategic ones - these three domains being always closely intertwined when it comes to oil. 

The key question that comes to mind is whether this steep drop in prices is the result of cyclical factors - economic stagnation in Europe, the slowdown in countries such as China, Brazil and Indonesia - or whether it reflects a more fundamental trend. 

The most likely answer is the latter. On the one hand, the demand for fossil fuel will continue to grow for the foreseeable future, whatever progress is made in the development of alternative energies, with emerging markets - the new growth countries - representing more than 80 per cent of the increase in demand for the next 20 years. 

But on the other hand, we are just beginning to see the impact of the shale oil and gas revolution in the United States over the last few years, which has turned on their heads many assumptions regarding the global oil picture. 

As has been often mentioned, the United States is well on its way to becoming energy self-sufficient over the next 15 to 20 years and has already reduced very substantially its reliance on external energy sources, with oil and gas imports declining steadily since 2009. 

As an example, Nigeria - which used to be the fifth external supplier of oil for the United States - has not exported a single barrel to this country since July. 

The United States shale oil and gas revolution is complemented by a similar development in Canada and the soon to be felt impact of the structural reform of the energy sector in Mexico, which should rapidly translate into additional production capacity. 

So a slowing down of demand combined by an increase in supply capacity is bound to create a sustainable downward pressure on prices. 

There are, of course, clear winners and losers from this trend. Among the winners come the economies of countries completely dependent on oil imports, with India and Japan coming first to mind; but also the consumers in Europe and in the United States - Moody's estimates $1.2 billion in savings for United States consumers for each percentage-point decline in the price of gasoline every year. 

On the losing side, one has to look at Russia whose economy - already on the verge of recession - is so dependent on oil revenues; at countries such as Venezuela, on the verge of bankruptcy; and Iran. The Tehran regime is crucially dependent on its oil revenues to finance the subsidies that help maintain social stability. It is now selling oil at $85-86 a barrel, against $114-115 a barrel last spring. 

One can imagine the impact on the Iranian economy as this steep drop in prices is aggravated by a reduction of production since July. 

The picture is more complex when it comes to Saudi Arabia. Riyadh has so far refused to reduce its production to contain the decrease of oil prices. The key strategic objective for the Saudis is to preserve their role as the global swing producer and the economic and strategic benefits gained from such a privileged position. 

So they seem ready to stomach the loss created by declining prices. The fact that Saudi Arabia has around $750 billion of reserves makes it relatively easy for the kingdom to sustain a sharp decline of revenues for the time being. 

It could expect that the sacrifice would be worth it if such a decline in oil prices were to hamper the development of United States shale oil and gas that require higher energy prices to be economically sustainable. 

Thus, Saudi Arabia would be able to "neutralise" or to slow significantly the development of a competition that threatens its role as a swing producer capable of shifting the global oil market in one direction or the other. 

However, the regime in Riyadh has to take into account some troublesome realities: first, Saudi Arabia's per capita energy consumption is the highest in the world due to a considerable waste of energy that all efforts deployed so far have been unable to constrain. 

Saudi Arabia has now to take away three million barrels a day for domestic consumption and an even higher percentage of production will be eaten up by domestic needs in the coming years. 

Second, the regime has had to devote more and more subsidies and handouts in the last few years to trying to assuage the growing frustration of the young and a fledgling middle class that is more and more exasperated by the lack of freedoms and rigidities imposed on Saudi society, thanks to religious taboos enforced by a hated religious police. 

The regime is now spending an estimated $130 billion a year on subsidies, and pressures are mounting given the explosion of the population from 20 million people in 2000 to 28.5 million in 2013 - and increasing water scarcity. 

Five year ago, Saudi Arabia needed an oil price of about $85 a barrel to balance its budget. Today, it needs $100 a barrel. 

So the Saudis will have to calibrate their position in the coming period. According to some estimates, pushing a barrel of oil back to around $100 would require a reduction of production of about two million barrels a day - a cut that would fall predominantly on Saudi Arabia. Riyadh may expect to face some pressures at the next meeting of Organization of the Petroleum Exporting Countries, scheduled for mid-November. 

Any calculation by the Saudi rulers on their oil strategy will almost surely be influenced by their concerns about what they perceive as the Obama administration bending backwards to get an agreement with Iran on the nuclear issue - which would re-establish the international legitimacy of Tehran and impact negatively on Saudi Arabia in its contest for power and influence in the Gulf. 

However, the situation is also complex - albeit in a different way - in the United States.

The tremendous benefits derived from the decline of oil prices for the American consumer have to be weighed with the impact such decline might have on the development of shale oil and gas, and, thus, on the United States achieving its strategic objective of energy self-sufficiency by 2030-35. 

The shale industry should be able to pursue its development at price levels of $80-85 a barrel. The key issue is, thus, to ensure that prices don't drop further. But the dynamics of the market are difficult to predict at the moment. 

As a new global picture for oil is emerging the levers of control of the market are changing hands and the rationales for decisions on production levels and prices are also changing. 

If the United States emerges as one clear winner of the present shift, and countries such as Russia and Iran as losers, there is no way this will not have strategic and geopolitical implications in the medium term. 

The rulers in Riyadh are certainly pondering their game very carefully at the moment to make sure that whatever they decide will help protect their position - and their alliances - in the future. 

The writer is president of Smadja & Smadja, a strategic advisory firm.

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