The U.S. still imports eight or nine million barrels a day, so on balance they are benefiting from this. In the same way, on balance, Canada is suffering from this.
Joseph Doucet
26
September
2016
|
23:00
America/Tegucigalpa

Why the world has too much cheap oil

UAlberta experts don’t expect prices to go up anytime soon as Saudi Arabia continues to play political long game in global oil squeeze.

By MICHAEL BROWN

As the world’s oil producers met in Algeria this week as part of the International Energy Forum, the world’s largest and most influential cohort—the Organization of the Petroleum Exporting Countries (OPEC)—met informally in the latest in a series of last-ditch attempts to rein in the world’s oil supply and give prices a sorely needed boost.

With hope fading, the group, for the first time in eight years, agreed to a modest cut in production from 33.24 million barrels per day down to 32.5 million. The markets reacted swiftly, pushing oil up against the $50-per-barrel mark. Though that is a far cry from $100 per barrel oil producers were getting at the midway point of 2014, the supply reduction may provide some measure of relief for oil-producing nations whose coffers were emptied soon after the onset of cheap oil.

Watching the oligopoly struggle over the past two years to act in what would appear to be its own interest has the casual observer wondering why.

It’s a complicated story, but a good one, and it starts in Saudi Arabia, which has more than 265 billion barrels of oil reserves that almost bubble to the surface.

Joseph Doucet, dean of the Alberta School of Business, says Saudi Arabia has traditionally been what is referred to as the oil cartel’s swing producer. This means that if Saudi Arabia cuts its output from seven million barrels a day to 6.5 million barrels a day, the price goes up for everyone. However, the increased price per barrel enjoyed by all comes at a cost to Saudis, who lose 500,000 barrels of output, an equivalent amount of market share and the subsequent profit they would have gained from the increased output.

“At the end of the day, what Saudi Arabia would like to have is $100 oil and larger market share,” says Doucet. “And in the past they would have reduced their production to keep prices high, but they essentially got tired of doing that.”

Doucet says the Saudis are playing a long game.

“Their game is to increase supply with the resulting impact on price. The Saudis accept that, for a little while, they will get smaller profit—their costs are still very low so they are still making money on every barrel.”

As less profitable barrels of oil came off the market at $30, prices have rebounded recently, although Doucet notes that Saudi Arabia was never concerned about what high-cost producers were bumped out of the market—even its best friend in the West, the United States.

 

“Even though they produce more than they used to, the U.S. still imports eight or nine million barrels a day, so on balance they are benefiting from this. In the same way, on balance, Canada is suffering from this.”

What the Saudis do care about, however, is some of their geopolitical enemies, which provides the context behind the supply-and-demand facade.

From Cold War to Arab Spring—and back?

The politics in the region go back centuries, but according to Mojtaba Mahdavi, a professor of political science at the University of Alberta, current tensions in the region related to oil originate in the midst of the Cold War, with the 1979 Soviet Union invasion of Afghanistan—a bloody and ultimately unsuccessful occupation that lasted a decade.

With mutual fear of a communist influence in the Middle East, Saudi Arabia and the United States entered an alliance that would bring the U.S.-Soviet Union proxy war to the Persian Gulf—a behind-the-scenes struggle that still wages today.

The two superpowers would pick sides again in the 1980s when Saudi and U.S.-backed Iraqi forces invaded Iran over a political-ideological and border dispute.

Over the intervening decades—punctuated by the fall of the Soviet Union, multiple U.S.-led invasions of friend-turned-foe Iraq, 9/11 and the subsequent U.S. involvement in Afghanistan, the onset of the Arab Spring uprisings and the rise of Vladimir Putin’s Russia—the West’s long-held fear of Iran’s nuclear aspirations gave rise to an anxious diplomatic clash that resulted in a series of crippling embargoes, including a ban on Iranian oil exports.

Everything changed in the spring of 2015, when improving international relations resulted in an Iran nuclear power deal, which effectively welcomed the embattled nation and its oil—upwards of 1.5 million barrels a day by year’s end—back to the international arena to compete for economic and political dominance in the region.

“When Iran and the Western countries came to an agreement over Iran’s nuclear issue, almost all hardliners in the region opposed the deal. They felt that a successful nuclear deal would ease the tension between Iran and the West and will have some impact on the balance of power in the region,” says Mahdavi.

More recently, Iran and Russia’s support of the Syrian government against ISIS put a spotlight on political differences in the region and renewed old allegiances not seen since the Cold War.

Complicating matters further was the western world’s early support of the Arab Spring uprisings, which originally pitted the West, along with conservative Arab countries headed by Saudi Arabia and Turkey, and all Islamist organizations including ISIS and the Muslim Brotherhood—against the Assad regime in Syria.

“All of a sudden things started to change when ISIS attacked Europe, and perhaps Western countries realized they were playing with a monster and had to change their policy,” says Mojtaba Mahdavi.

“Some of the Western countries trained, funded and armed some of these groups aligned with Saudi Arabia—not because they love these guys but because the goal was to get rid of Assad,” says Mahdavi. “All of a sudden things started to change when ISIS attacked Europe, and perhaps Western countries realized they were playing with a monster and had to change their policy.”

Realizing that the U.S. was backing away from its ardent support of a regime change in Syria and sudden tolerance of Iran’s nuclear program, the Saudis had to find other ways to put pressure on Iran and Russia for their support of the Assad regime, Mahdavi says. That other way is oil.

“Everything is related to everything.”

The end of oil? Not so fast

Refusing its traditional role as a swing producer, Saudi Arabia has opted for the status quo. With the world’s oil producers unable to agree on limits, the price of oil tumbled, hitting historic lows in early 2016 that led to an economic slump felt around the world.

Another unintended consequence has been the self-inflicted damage done at home. Business professor Emilson Silva says Saudi Arabia’s stance has meant they are now struggling to defend their dollar.

“They don’t want to float their currency because that would bring about huge devaluation of their currency, but they are paying a lot to keep it where it is. Think about what happened to the loonie as oil went down.”

Silva says Saudi Arabia has also made a huge commitment toward improving or expanding infrastructure investment based on oil being above $100 per barrel. “It is really hard to move away from that.”

He points to Venezuela’s catastrophic situation, as well as some of the fragile economies that depend on the price of oil that are in dire straits right now.

“There is a continuous push to establish a ceiling in OPEC. Iran is not willing to do this before they manage to produce as much as they were producing before the embargo.”

He says if OPEC were to effectively reduce its supply, it would have to take into account that Iran is going to expand production up to 1.5 million barrels by the end of the year, and that all the other countries would have to reduce their supply by much more than 1.5 million barrels a day.

“Who is going to be willing to do that? If not Saudi Arabia, who then? It’s a really tricky situation.”

As it is now, Silva says, if oil prices were to continue around the $50 mark, some of the production in the United States will come back online, as will fire-ravaged Fort McMurray and places like Nigeria, which has seen terrorism take its toll on output.

“The economic fundamentals indicate to me that the excessive supply will continue and even expand throughout the year,” says Silva. “Without knowing what the Russians are going to do and with individual members of OPEC unable to agree, I don’t see any reason prices will go up.”

Yet despite high-cost oil producers in Canada, the U.S. and Brazil sitting on the sidelines, income from oil down everywhere and renewables seemingly making inroads, Silva says the demise of oil has been greatly exaggerated.

“I don’t see oil ending anytime soon, given the fact that there is plenty and it is very cheap,” he says. “The world would need something dramatic that goes beyond climate change, an imminent collapse in the global system that has a major effect on a number of major centres.”

He says the shift away from fossil fuels will continue to be gradual, as he doesn’t see anything in the industry that will increase investment in such dramatic fashion.

Ironically, Silva says, a lot of investment in renewables came when the price of oil was high.

“Right now the impetus for doing that is much lower. If the price of oil as an energy source is very high, substitutes become viable. But as oil comes down those other sources are still expensive.”