Oil-producing nations struggling for market power as prices drop

Washington: There's a lot of handwringing these days over the barrel bombing of innocent communities in Syria; over the flight to Europe by hundreds of thousands of Syrian and Iraqi refugees; and over the failure to date by the militaries of the world to end the nightmare of the so-called Islamic State.

Meanwhile, on Friday the price for the benchmark Brent crude oil was $US34 ($48) a barrel and Australian motorists were driving away from service stations, tanks filled with petrol priced at close to 90 cents a litre.

A gas flare at the central processing plant for oil and gas in the Salym oilfields in western Siberia. Credit: Alexander Zemlianichenko

The slide in oil prices threatens to be as disruptive as the 1973-74 oil shock, when prices jacked up 300 per cent in just six months. Cheap petrol is a boon to be sure, but Carnegie Endowment fellow Moises Naim warns that in world affairs, we need to be mindful of the consequences of the consequences of such events.

Less apparent than the plummeting crude prices is a white-knuckle struggle for market power among the world's oil-producing nations.

Cheap petrol prices could spell doom for oil-revenue dependent nations such as Saudi Arabia, Iraq and Libya.Credit: Bloomberg

Think of it as a new cold war, in which the price of a barrel of crude has dropped by as much as 70 per cent since peaking at $US115 in June 2014. Some analysts say we have yet to hit bottom.

On Thursday, Royal Dutch Shell and ConocoPhillips were the latest of the oil majors to report catastrophic "casualties" in this other war, which has forced the suspension, globally, of oil and gas projects worth almost $US400 billion ($556 billion); along with the loss of more than 250,000 jobs.

Shell's profits collapsed by 56 per cent in the December quarter, topping off an 80 per cent rout for all of 2015. The company shed about 7500 jobs; thousands more are to be axed; and it has mothballed two huge development projects – one in Canada, the other in Nigeria. ConocoPhillips slashed shareholder dividends by 66 per cent on the back of a 42 per cent fall in revenue.

The fate of corporations is one thing. But this oil war threatens the fate of nations.

A Nigerian tribal chief stands alongside an abandoned oil wellhead, known as number 1 and previously operated by Royal Dutch Shell, in marshland in southern Nigeria.Credit: Bloomberg

From Riyadh to Moscow to Caracas to Abuja to Baku, agencies like the International Monetary Fund are sweating as capitals that previously sloshed in petrodollars can't make budget and some are looking for a bailout.

To balance their books, Libya, Iran, Algeria, Nigeria, Venezuela, Russia, Saudi Arabia and Iraq – each involved in high-stakes geopolitical struggles – all need as much as a threefold increase in today's oil price. The United Arab Emirates, Kuwait and Qatar need a two-fold increase.

A visitor passes ENOC-branded oil barrels stored at the Emirates National Oil Co. Credit: Bloomberg

Many of these are nations that have known only subsidies – and certainly nothing as rude as income taxes. But that's changing, especially in the Gulf countries, where long-standing subsidies for energy, water and electricity are being ditched; and increasingly, the T-word – tax – is being uttered as a near-term inevitability.

In Russia, where energy exports fund about half of the federal budget, interest rates are at 17 per cent and the ruble is being hammered – in late January it fell to a record low, 85 to the US dollar. Russian factory workers complain they are not being paid and food prices are reportedly up by as much as 30 per cent on last year.

The sliding oil price has been the icing on the cake for miners.

And with oil prices getting dangerously close to the average per-barrel production cost in Russia – reportedly about $US15 ($21) – Moscow is warning of tax increases and axing social security programs.

In Iraq, banks are running out of cash; hospitals and other institutional services are as bereft as they were in the "oil-for-food" sanctions days of the 1990s; and the Kurdish Peshmerga fighters in the north, the only force with a proven record of whipping Islamic State, complain that they have not been paid for months.

The slide in oil prices threatens to be as disruptive as the oil shock of the '70s.Credit: Simon Dawson

Baghdad was able to rely on oil revenue of $US8 billion a month in 2014, a full half of which went to government salaries; but in December 2015, Baghdad's oil revenue was less than $US3 billion.

Former Iraqi national security adviser Muwaffaq al-Rubaie warned last week: "Eighteen months ago, [IS] was the existential threat to Iraq [but] we managed to push it back. Now, the existential threat is financial bankruptcy."

Saudi Deputy Crown Prince Mohammed bin Salman bin Abdulaziz, in Paris last year.Credit: Getty Images

In Moscow and Baghdad, governments are being warned that any further tightening of public salaries or of services that constitute the local "social contract" are likely to provoke unrest. In the Middle East in particular, there is a risk that public anger could be exploited by IS, al-Qaeda and the like.

At current spending rates, Moscow is warning that it could clean out its emergency Reserve Fund, which in late 2015 reportedly held $US70 billion, as it attempts to cover budget shortfalls.

In the case of the Saudis, Riyadh depends on oil sales for more than 70 per cent of government revenue, but last year it reportedly chomped through $US100 billion of its financial reserves – which now stand at $US630 billion ($876 billion).

Market logic dictates that tighter supply would force up demand – and thereby cause prices to rebound. But in this battle, none of the heavy-hitters will blink.

In the Arab-dominated Organisation of Petroleum Exporting Countries, Venezuela, an economic basket-case despite its massive oil reserves, backed by Ecuador and Algeria, are pressing for across-the-board production cuts in a bid to force up prices. But most producers simply can't afford to forego the revenue gained by maximum production – at any price per barrel.

And in the name of protecting or growing market share, Iraq and Iran want helter-skelter access to the market. Four years of Western sanctions on Tehran, which were lifted in January, suppressed Iranian production by about a million barrels a day, forcing it from No. 2 to No. 7 in the ranks of world oil producers.

But Riyadh is the elephant in the room, because Saudi Arabia is the oil market's only "swing" producer – that is, a country that can vary production according to market fluctuations; keeping supply and demand in balance and prices "just right". The price has gone through the floor because no big producer wants to tighten the spigot, least of all the Saudis, who "own" close to 10 per cent of the global market.

Riyadh's thinking is as much geopolitical as it is commercial.

In the last few years, US oil production has almost doubled, dramatically pushing the US up the production rankings – to No. 2 after Saudi Arabia. And as tension has infused the Washington-Riyadh relationship, first over the Arab Spring, then the Syrian conflict and most recently the Iran nuclear deal, Riyadh was quite happy to punish the Americans by forcing the selling price of oil below the per-barrel cost of production in the US.

At the same time, the Saudis were happy to inflict deeper low-price pain on Moscow and Tehran – because of their backing for Syrian dictator Bashar al-Assad. Some analysts cast Russia's military intervention in Syria as a direct response to that pain.

The upshot is a glut. With China and other energy-hungry economies slowing, as much as an extra million barrels of oil comes into the market daily, further squeezing prices – and storage facilities, to the extent that some of the excess is being warehoused on supertankers that just bob at sea, going nowhere.

Looking for good ways out, analysts start to sound a little desperate. A good war between Iran and Saudi Arabia would help soak up the over-supply, says one media analyst; and on Iraq, he suggests action by Islamic State or a shortage of water might usefully drive down production.

In the midst of such crises, the calcified nature of Saudi governance raises questions about its capacity to adapt – its economy is grossly inefficient and almost entirely energy dependent; it redistributes wealth through a vast system of public subsidies and there's no income tax.

There is virtually no political representation under a repressive regime that typically throws money at problems to make them go away – in the face of the Arab Spring push for democracy in the region, Riyadh showered an estimated $US130 billion on its people to keep them in line; and reminded them of the consequences of stepping out of line by sending its tanks into neighbouring Bahrain to put down protests there.

In the wake of unveiling the country's biggest ever budget deficit, the IMF this week warned the kingdom that in the absence of severe austerity measures, low oil prices could ruin it within five years – a dire forecast that was based on a generous oil price of $US50 ($70) per barrel, well above Friday's $US34.

This then is the context in which a new generation of Saudi princes is grasping for the levers of power. Leading the charge is Mohammed bin Salman, who became second-in-line to the throne in January last year.

Dubbed by The Economist a "young prince in a hurry", the 30-year-old king's son plans to remake the entire Saudi state.

He's ready to abolish all subsidies, raise taxes [not an income tax, mind you], privatise the likes of health and education; telcos, power stations and the national airline; and, if he can be believed, the jewel in the Saudi crown, Aramco, the national oil and gas company that is the world's biggest company and a piggy bank for princes.

In five years, Prince Mohammed says, Saudis will be paying market prices for water, electricity and petrol and the pay-for-no-work public service will shrink dramatically as a self-funding private sector takes over. But please, don't waste this man's time with questions about human rights and political reform.

The prince's outpourings on his grand reform designs prompted this sober assessment by al-Bab, a website specialising in Middle Eastern affairs: "[He talks of] not just an economic upheaval but a political one too. It's the classic pre-revolutionary scenario, seen many times in history, where an expiring regime attempts to reform – only to discover it has left things far too late."

The business news agency Bloomberg reported "shock and laughter" among senior bankers in response to the proposal to privatise Aramco – in particular because such a deal requires a degree of financial and economic transparency of which the highly secretive Saudis are deemed incapable; and also, because volatile prices and the drive for non-fossil fuel alternatives make the proposed IPO too late and probably too unattractive to investors.

Columbia University's Professor Stephen Sestanovich is more explicit, seeing a precedent for the petrostates in the disintegration of the old Soviet Union as the reformist Mikhail Gorbachev battled low oil prices.

"For the Saudis the parallels must be unnerving," he writes in The Wall Street Journal, wondering if current crises might strangle the kingdom.

"Growing ethnic divisions and the military's huge share of the economy round out the picture. To all this, add a sharp drop in [oil] export earnings, and it's no surprise that people worry about systemic failure," he says.

All wars are dangerous. Wars of attrition – long, cold wars in which no one blinks – are especially so.