What is behind the Steep Decline in Crude Oil
The crude oil price has lost 54% of its value since September 2014 and there are no indications that it will stop there in the absence of a major production cut by OPEC. It is not inconceivable that the price could even slide to $40 a barrel.
The reasons given so far for the steep oil price decline is glut in the global oil market caused by rising US shale oil production and a slowdown in economic growth in China and the European Union (EU) reducing the demand for oil. This was exacerbated by OPEC's very wrong decision not to cut production by at least 2 million barrels a day (mbd) to absorb the glut in the oil market. Had they cut their production, Russia and Mexico would have joined them and cut production by 500,000 barrels a day (b/d) and 300,000 b/d respectively, a total of 2.8 mbd capable of removing the glut and stabilizing the oil price. It is not too late for OPEC to reverse their earlier decision and cut production. Failure to do so could push the oil price down possibly to $40/barrel.
Still a glut in the global oil market estimated at 1-2 mbd and a slightly slower economic growth in China and the EU should not have led to such a steep decline in oil prices. The global economy suffered harsher and more dire banking and economic crises during the period of 2009-2011 and still the oil prices never declined as steeply and for such a long time.
Circumstantial evidence suggests some political collusion between Saudi Arabia and the United States. Though Saudi Arabia and the US can't increase production beyond current levels, Saudi has a substantial volume of stored oil which it could release into the market when needed.
Saudi Arabia took advantage of the low oil prices to inflict damage on Iran's economy and weaken Iran's influence in the Middle East in its proxy war with Iran over its nuclear programme whilst the United States is taking advantage of the low oil prices to weaken Russia's economy and tighten the sanctions against Russia over the Ukraine.
A continuation of low oil prices could damage the global economy in many ways. Whilst oil consumers around the world will enjoy for a short while low crude oil prices, eventually global consumption will overtake global production and that will push oil prices steeply up. Already crude oil's plunge has fuelled a big jump in US petrol demand. Current low oil prices could be planting the seeds for a future damaging oil crisis in the next two years.
The challenges facing the global economy in 2015 are manifold. One important challenge is a curtailment of global investments in many sectors of the global economy particularly the oil and energy sector. Another is a sustained damage to the global oil industry. The seven major oil companies in the world need a price of $125-$135/barrel to balance their books. They also need certainty about the future trend of the oil prices before committing themselves to huge investment in exploration and production. As a result of declining oil prices, the oil majors have already started to sell some of their production assets and to reduce their future investments which will translate in two years' time into a smaller share in the global oil production. This will be reflected in steeper oil prices in the future. Moreover, the economies of the Arab Gulf oil producers and also Iran's and Russia's which in total account for around 6% of the global GDP, could be hurt by the low oil prices. The combination of the above challenges could damage the global economy.
The Saudi oil minister Mr Ali Naimi seems to have lost the plot in trying to defend OPEC's earlier decision not to cut production. In an interview with MEES on December 21, 2014, he said Saudi Arabia and OPEC were defending their market share. "If they have cut their production, the price will go up and the Russians, the Brazilians and US shale oil producers will take Saudi and OPEC share". But Mr Naimi must have missed the point that if every producer tries to defend its market share, they all end up exacerbating the glut in the market and all of them will be losers.
The Saudi oil minister gave another reason for not cutting production by saying that we wanted to tell the world that high-efficiency producing countries like Saudi Arabia and other OPEC producers are the ones that deserve market share. In other words, countries who have proven reserves but high costs of production should leave the arena open for more efficient producers. It is a unique concept which, I am sure, high-cost producers will vehemently reject.
In another of his recent statements, the Saudi oil minister said that even if the oil price declines to $20 a barrel, Saudi Arabia will not cut production. This is more bravado than common sense. He admitted that the Saudi budget will have a deficit as a result of declining oil prices but he said he could borrow from the banks and use some of the country's financial reserves to cover the budget. It does not make any economic sense to sustain a deficit in your budget when it is within your power to prevent it. If oil prices continue at $50/barrel for a year, Saudi Arabia will lose an estimated $128 bn.
Saudi Arabia is forecast to reduce state expenditure to $229 bn this year, down18% on 2014, a clear sign of the impact the slum in crude prices is having on the finances of the world's largest exporter. It will end up with a $38 bn deficit amounting to 9% of Saudi GDP. As a result, Saudi Arabia's non-oil economy would contract by 5% this year.
Iranian President Hassan Rouhani said that countries behind the fall in the global oil prices would regret their decision and warned that Saudi Arabia and Kuwait would suffer alongside Iran from the price drop. He added that "If Iran suffers from the drop in oil prices, other oil-producing countries such as Saudi Arabia and Kuwait will suffer more than Iran. In 2013 oil accounted for roughly 90% of Saudi Arabia's overall budget income and Kuwait at 92% according to Reuter's calculations based on official data. On the other hand, only a third of Iran's budget is based on oil sales, with an estimated 60% of the country's exports tied to oil.
The global economy can't reconcile itself with low oil prices for a long while. That is why I am convinced that oil prices will start to rebound. My projection is that the oil prices will start to recover by the second quarter of 2015 and could recoup most of their losses.
*Dr Mamdouh G. Salameh is an international oil economist, a consultant to the World Bank in Washington DC on oil & energy and a technical expert of the United Nations Industrial Development Organization (UNIDO) in Vienna. He is director of the Oil Market Consultancy Service in the UK and a member of both the International Institute for Strategic Studies in London and the Royal Institute of International Affairs. He is also a visiting professor of energy economics at the ESCP Europe Business School in London.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the position of ESCP Europe Business School.