Tuesday, March 22, 2011

Politics and the Price of Oil

Governments have been replaced in Tunisia and Egypt. Rulers in Bahrain, Yemen and Libya are struggling to hang on. Of these countries, only Libya is a significant source of oil, producing a mere two percent of the world’s consumption. Why have these events then had such a large effect on the market price of petroleum? Two recent articles shed some light on the highly disproportionate price increases that have ensued. Edward L. Morse has provided Oil and Unrest in Foreign Affairs. The Economist has chipped in with The Price of Fear. The titles of these articles provide a clue to the ultimate conclusion: it is not what has already happened so much as what could still happen.

Morse provides historical background to put today’s events in perspective.
“Between 1981 and 1985, the price of oil fell from $35 a barrel to $10, and then stabilized at around $20 a barrel for much of the 1990s (although it did plunge once again in 1998 to $10). Over the same period, the populations of OPEC countries started to mushroom, as both life expectancy and fertility rates rose. With oil revenues falling and populations growing, per capita income began to decline. Yet governments did little to diversify their economies; in fact, oil-producing states did not begin to invest in diversification and increase spending on social welfare until the spectacular rise in oil prices. (Other oil producers, Libya among them, did not even try.)”

“This neglect contributed to the many factors underlying the current wave of civil unrest, especially to the region's stagnant incomes and unemployment rates. Now, with the contagion spreading to the oil-congested area of the Arabian Peninsula and Persian Gulf, the likelihood of an oil apocalypse is no longer implausible: in such a scenario, domestic upheaval would bring civil strife and violence, which in turn would lead to a reduction or cessation of oil production. A true apocalyptic scenario would see these events take place in major producers such as Saudi Arabia.”
The real price driver is the perception of Saudi Arabia’s ability to increase production to compensate for losses elsewhere. The Economist contributes this:
“The spread of unrest to Bahrain, Oman and the Gulf has created a whole new dimension of anxiety. North Africa produces 5% of the world’s oil, but the Middle East produces 30%. Moreover, Bahrain’s problems are on Saudi Arabia’s doorstep. These bear on the situation in the eastern Saudi provinces, from which a huge quantity of oil is pumped into global markets.”

“Saudi Arabia is therefore the traders’ chief worry. But it is also, in oil terms, the world’s chief hope. It is the only producer with significant spare capacity that could quickly be released if the oil price rose too high. Although OPEC, in which Saudi Arabia is the biggest force, exists to keep oil prices buoyant, it does not want to see them reach a point where the world economy is damaged and demand for oil falls. When prices spiked in 2008, the Saudis said they had capacity to spare. Terrified oil markets doubted its existence, and prices rose anyway, to reach $145.”
The Economist also provides this chart which illustrates how spare petroleum production capacity has changed over time.

Note that with Libya unavailable and the potential for Algeria to become unavailable, the spare capacity is back to the levels in 2008 when prices jumped to over $140—assuming you believe Saudi Arabia’s claims.
“OPEC’s spare capacity now is put at anything between 6m b/d (by OPEC) and 4m-5m b/d (by industry analysts); Saudi Arabia’s share of that excess is perhaps 3m-3.5m b/d.”
Although Libya appears to be a small producer, a decrease in its output can have a disproportionate effect.
“When oil markets tighten, another set of problems emerges. Saudi oil is generally more dense and sulphurous than the Libyan crude it will replace. Europe’s creaky old refineries will not be able to process the heavier Saudi crude, and fuel regulations there are less tolerant of sulphur content than elsewhere in the world. So the Gulf oil will have to be shipped to Asia’s newer refineries, which are designed to deal with a wide variety of grades of oil. West African oil, a close substitute for Libya’s output which usually goes to Asia, will be sent to Europe instead.”

“If the supply situation worsens, opportunities for this type of substitution will be fewer, creating supply bottlenecks, shortages of petrol and spikes within price spikes for different crudes and products, even when spare capacity remains.”
Higher oil prices mean lower economic growth. Before the financial collapse, the $140 per barrel cost was probably driving us into a recession anyways.

While many of us do not like the governments in power in North Africa and the Middle East, it may be time to say “enough is enough.” If Saudi Arabia and its ability to pump oil were to appear the least bit threatened, the results could be catastrophic for the world economy.

Let us conclude with Morse’s outlook for the future.
“The many domestic factors that have led to the recent turmoil across the region are not going to disappear in 2011. Virtually no oil-producing country in the region has been able to diversify its economy away from oil. Almost all are seeing domestic oil consumption rising rapidly as governments subsidize gasoline, diesel, and power in an attempt to deliver material well-being to their citizens. Cheap energy is critical to the legitimacy of these regimes, making price spikes politically difficult. So far, only Iran has been able to raise domestic gasoline prices -- and that is only because of its lack of refining capacity and the squeeze of the U.S.-led embargo on gasoline deliveries to the country. Oil consumption within the Gulf countries rose from 4.8 million barrels a day in 2000 to 7.8 million in 2010, eroding exports and raising the minimum price of oil needed for oil-producing states to break even on their extraction and production costs. As a result, those states dependent on oil from the region are facing troubling prospects: a near-term loss of supply due to the current disruption and a longer-term loss of supply due to growth in domestic consumption.”

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