Middle East Uncertainty and Oil Price Stability

In this edition of Iqtisadi: Middle East Economy, Dr. Paul Rivlin analyzes the fact that, despite the deep unrest and instability in the region, oil prices are nevertheless forecast to remain steady.

The Middle East is burning. Four countries – Syria, Iraq, Libya and Yemen – have ceased to exist as unified states and are being consumed by war. Tension between Iran and Saudi Arabia is at a peak and a solution to the Israel-Palestine conflict looks as remote as ever. Egypt is plagued by both terrorism and huge socio-economic problems. In addition, the whole region faces a major water crisis that threatens both short term stability and long term development. Given all this, and the fact that nearly 50 percent of world oil reserves and almost a third of world oil production comes from the region, it seems incredible that oil prices are not only relatively low but that many experts think they will remain so.

Between the summer of 2014 and January 2015, oil prices fell sharply. Since then they have risen modestly but remain at about half of their July 2014 level. Against this background, the Organization of Petroleum Exporting Countries (OPEC) decided at its June 2015 conference to leave production quotas for member states unchanged. This continued the policy announced at its previous meeting in November 2014, which maintained the OPEC production level at 30 million barrels a day (mb/d).

At its June 2015 meeting, OPEC recorded its continued concern over market volatility and the challenges faced by the global oil industry, and noted that the sharp decline in oil prices witnessed at the end of 2014 and the start of 2015 was caused by oversupply and speculation. These forces have abated, with prices moving slightly higher in recent months. OPEC recognized that world oil demand, mainly driven by non-OECD countries, is forecast to increase in the second half of 2015 and in 2016. On the supply side, non-OPEC growth in 2015 is expected to approach 700,000 barrels per day, which is only around one-third of the growth witnessed in 2014. It also observed that the recent increase in oil stocks in both OECD and non-OECD countries has resulted in levels that lie well above the five-year average, indicating that the market is comfortably supplied.

Factors suggesting that oil prices will remain at present levels are numerous. First, OPEC is producing above its overall quota of 30 million barrels a day and it has done nothing to reduce production. Iraqi production rose by over 10 percent during the first four months of 2015, despite the intensity of fighting inside that country. Libya, another country facing internal conflict, also increased production by almost 53 percent. Production in Iran, Kuwait, Qatar and the UAE was largely unchanged, but Saudi Arabia increased output by over 400,000 barrels a day, a four percent rise.

In May 2015, the International Energy Agency (IEA) stated that it is too early to declare that OPEC has won the battle for market share. But in fact, the battle has only just begun. In November 2014, OPEC’s core Gulf members decided not to cut production in defense of prices. This was the first step in a plan that included increasing output and aggressively investing in future production capacity, while non-OPEC counterparts keep tightening their belt. Bucking the global trend, Kuwait, Saudi Arabia and the UAE raised their rig count and expanded their drilling programs. Iranian production has reached its highest since July 2012, when international sanctions on Iran’s crude exports came into effect. Talks with the P5+1 raise the possibility of its full return to international markets; Iran is expected to return to the oil market with the lifting of sanctions and this probability hangs over the market, which helps to reduce expectations of price increases.

OPEC's decisions were based on Saudi interests backed by those of its allies in the GCC. In November 2014, Saudi Arabia pushed OPEC to protect its market share in the face of increasing U.S. crude output, rather than to cut supplies in order to shore up prices as it had done in the past. Having abandoned the role of swing supplier – by adjusting production in line with demand – Saudi Arabia is maximizing sales in order to increase pressure on producers outside OPEC.

The most dramatic change on the supply side has been in the United States. Between 2008 and 2014, US oil output increased by 72 percent, making it the world's third largest producer after Saudi Arabia and Russia. Although the US bans crude exports, its imports have plummeted. This, along with lower Chinese demand, resulted in a glut on world markets. Other producers have decided not to try to curb their production and keep the price up. The US shale production boom is based on new techniques—fracking and horizontal drilling—and unlike traditional “big oil,” involves small companies and small projects. These are flexible and that means they are able to respond rapidly to price changes. Furthermore, they are innovative and huge productivity gains are thought to lie ahead.

The United States is also exporting substantial volumes of refined products, resulting in a decline in its total net imports from over 14 million b/d in 2006 to just under 6 mb/d in 2014. It is very unlikely that China will take on all the excess volume available from both OPEC and non-OPEC producers (mainly Russia). Saudi policy has prioritized the protection of the kingdom’s market share, rather than oil profits. Hence, when in December 2014, Saudi oil minister Ali Al-Naimi announced that the kingdom would maintain production at over 9 million b/d, prices went from $110 per barrel to as low as $46 per barrel. While prices have recovered substantially, to about $67 per barrel, even at this price Saudi Arabia will have a budget deficit in 2015 of about $40 billion, excluding undisclosed military expenses.

Factors suggesting that oil prices will rise include increasing oil consumption in the Gulf that will reduce the amount of oil that can be exported and a recovery in the world economy will increase demand for oil. A tightening of supply because of conflict in the Middle East or involving other oil producers might also result in higher prices.

In May 2015, the Islamic State (IS) set fire to the enormous Baiji oil refinery, located 100 miles north of Baghdad, and which they had captured the previous June. The decision to torch the refinery, which once produced around a third of Iraq’s domestic fuel supplies, was made as the insurgents prepared to pull out of Baiji. Although IS attacks in Iraq reduced northern Iraqi production and refinery operations, they did not affect southern production and exports, that in 2014 accounted for 95% of Iraq's total crude oil exports. The IS did not significantly affect production in the autonomous Kurdistan Region in northern Iraq, although fighting came very close to fields produced under the auspices of the Kurdistan Regional Government. According to the US government Energy Information Agency (EIA), a number of oil companies were forced to abandon exploration projects, which could delay future development.

Following the start of the IS offensive, Iraq's crude oil production fell to its lowest monthly levels during July and August 2014. From August to December 2014, Iraq's production grew by almost 600,000 barrels a day, which reflected increased output from fields in southern Iraq and in the Iraqi Kurdistan Region following infrastructure development, and a partial recovery in northern Kirkuk production. In December, Iraq's crude oil production reached 3.75 mb/d, its highest level ever. In 2014, Iraq was the second largest contributor to world supply growth after the United States.

Oil markets have shrugged off the risk of a major supply disruption caused by the worsening security situation in Iraq, Syria and Yemen. Traders have remained focused on the fact that almost 2 mb/d of excess oil capacity available in Saudi Arabia will be more than enough to absorb any supply-driven shock. The rise in the price of Brent crude – a global benchmark – which began in January 2015 and saw prices push close to $70 per barrel lost momentum amid signs that higher oil prices could revive drilling in the US. In November 2014, when OPEC oil ministers met in Vienna, the cartel decided to continue pumping oil at a level of around 30mb/d, which effectively fired the first shots in an oil price war against shale drillers in North America and Russia. OPEC decided to act at that meeting after almost a decade of oil prices at above $100 per barrel, during which the group ignored the “shale revolution” taking place in the US. Under massive pressure from Saudi Arabia, its most powerful member, the cartel allowed market forces to drag down oil prices. The strategy worked and was maintained at OPEC's June 2015 conference.

The IEA has noted some important developments that will affect oil markets in the medium term. Unlike earlier price falls, the current one is both supply- and demand-driven, with record non-OPEC supply growth in 2014 providing only one of the factors behind it, while unexpectedly weak demand growth provides another. On the supply side, US shale extraction technologies, which at the time of the previous market correction barely registered as a source of production, have unlocked a vast resource that long seemed off-limits, and have profoundly changed the traditional division of labor between OPEC and non-OPEC members. The current price weakness is also occurring at a time when the dynamics of global demand and the place of oil in the fuel mix are undergoing dramatic change. Emerging economies, especially China - which 10 years ago seemed an unstoppable engine of demand growth - have entered a new, less oil-intensive stage of development. The global economy, reshaped by the information technology revolution, has generally become less fuel intensive and concerns over climate change, are causing a rethinking of energy policies. The globalization of the natural gas market, along with steep reductions in the cost and availability of renewable energy, are causing oil to face a level of inter-fuel competition that did not exist a few years ago.

The result is that, barring any unexpected supply disruption or major, energy-related change in policy, the market rebalancing will likely occur relatively swiftly but will be comparatively limited in scope, with prices stabilizing at levels higher than recent lows but substantially below the highs of the last three years. On current projections, the dramatic inventory build of the last few months will grind to a halt in mid-2015, and the market will then start tightening appreciably, with a steady and gradual increase in the demand for OPEC oil from 2016 onwards. The price decline, notwithstanding the sheer scope of the supply response that it has already dictated, will not succeed in derailing the underlying forces in motion in the market or alter its expected course of development. If anything, pre-existing patterns will emerge reinforced by the adjustment.

On the supply side, the top two sources of capacity growth – North America and Iraq – loom even larger by the end of the decade than previously expected. The price correction will cause North American shale development to pause but will not bring it to an end. By the beginning of the next decade, the region’s non-conventional production will account for an even larger share of the supply mix than has been earlier forecast. While estimates of its production have been adjusted downwards, still the region nevertheless leads global supply growth by a wide margin by 2020, with forecasted gains of 3.0 mb/d. Other sources of non-OPEC supply will be far more adversely affected by the price reset - none more than Russia, where production is expected to fall by more than 0.5 mb/d by 2020, down from an earlier projection of small growth.

In conclusion, it seems that the turmoil in the Middle East has neither constrained production nor put upward pressure on prices. World demand will be constrained by moderate rates of economic growth and increased environmental concerns. OPEC will try to avoid price rises that would result in an expansion of shale production in the United States and elsewhere, and that would result in attempts to reduce reliance of oil. Major disruption of production in the region would, however, have immediate effects on prices.