Meridith Kohut/The New York Times

OPEC Circles the Drain

by robert looney
 

robert looney teaches economics at the Naval Postgraduate School in California.

Published September 25, 2017

 

In the wake of the spectacular rise of small-scale fracking in the United States, has OPEC (in concert with other traditional petroleum producers) permanently lost its ability to control the global oil market? If the Saudis’ failed attempt to lean against price trends in 2014 and, more recently, the OPEC/Russian attempt to increase oil prices by trimming production are any gauge, the answer is yes.

For one thing, it is now apparent that U.S. shale drillers are willing and able to ramp up production in a matter of weeks — and to produce profitably at a market price of just $30-35 per barrel. For another, it is clear that Asian consumers (the only long-term source of growth in global demand) will switch sources when it is to their financial advantage. As a result, even in alliance with major non-OPEC producers like Russia, OPEC can no longer engineer an oil price increase without drastic (and unlikely) coordinated cuts to its members’ oil production.  

 
Russia and four of OPEC’s major producers share a zero-sum world of harsh geopolitical and economic realities with no obvious practical solutions.
 

Russia and four of OPEC’s major producers (Saudi Arabia, Iraq, Venezuela and Iran) face the prospect of shrinking oil revenues. By no coincidence, they share a number of liabilities that limit their economic flexibility. All have corrupt governments; all have failed to diversify their economies into non-hydrocarbon activities (though Iran has made a start). And all have largely ducked the economic and governance reforms that might have made their economies less vulnerable to what appears to be a permanent decline in oil prices. Theirs is now a zero-sum world of harsh geopolitical and economic realities with no obvious practical solutions. 

Saudi Arabia

The under-sand oceans of oil that could be extracted at low cost made Saudi Arabia the de facto leader of the Sunni Middle East — the one country that could afford to cut production sharply to enforce its wishes. But a depressed energy market combined with inexorable population growth (the population has tripled since 1981) has left Riyadh hard-pressed to find the tens of billions in cash needed to play this role, or to even maintain domestic social stability — much less finance impulsive military adventures like the war in Yemen. To make up for the shortfall in revenue, Saudi Arabia has chosen to sell shares in Aramco (the state-owned oil conglomerate) and to borrow money abroad for the first time in years. Indeed, the Saudis have apparently decided they can no longer afford to fight proxy wars with Shiite Iran and reached out to the country for detente.

On the domestic front, the Saudis are making a last-ditch attempt at economic diversification. But the move away from oil will not be cheap. Saudi Arabia’s Vision 2030 plan envisions a $4 trillion investment in eight non-oil sectors. The only way to pay for this will be to pump more oil, which will further suppress oil prices. And even if they raise the funds, there is no good reason to believe the Saudis have the social, educational and legal institutions to make a go of diversification.

Russia

While Russia can boast of pockets of technological excellence ranging from weapons to software, oil still generates 70 percent of Russia’s export revenues, and income from fossil fuels covers more than half of the government budget. Even before 2014 oil-price drops, Russian economic growth was decelerating due to structural constraints associated with shoddy infrastructure, crony capitalism and pervasive corruption. The economy is only now climbing out of three years of recession. And with reserves left from oil sales in the boom years nearly exhausted, Moscow is considering previously unthinkable cuts to defense expenditures as it struggles to finance state pensions.

From this perspective, Vladimir Putin’s adventures in Ukraine and Syria, together with its interference in the U.S. election, appear designed to distract from steadily worsening economic conditions that no one has a clue how to fix. One way or another, if Russia is to entertain any hope of remaining a world economic power (as opposed to a military and political power) in an environment of low oil prices, fundamental changes in the economy are a must.  

Iraq

Even as the Islamic State insurgency is being defeated on the ground in Iraq, violent sectarian protests have broken out across the country over the government’s inability to provide reliable electric power or to account for the billions generated in oil revenues. There has been no real reconciliation among the Sunni, Kurds and Shiite (who control the government). Added to this, the government faces the costs of rebuilding Mosul and other areas liberated from ISIS, which rough estimates place at around $100 billion.

To date, the Iraqi government’s only answer has been to increase oil production from its very large reserves, a dubious strategy since Iraq is a big enough player to affect the price by dumping more crude on the market. However, after squandering reconstruction funds in the 2000s and with corruption rampant in Baghdad, the Iraqi government can no longer expect international assistance to fund much-needed economic diversification or make up for budgetary shortfalls. With a reprieve in the form of a spike in oil prices unlikely, the mid-term future looks pretty grim.

Venezuela

Since 2015, the administration of Venezuelan President Nicolas Maduro has been fighting an uphill battle for political legitimacy, soldiering on despite nationwide protests. With little public support, the increasingly authoritarian Maduro government lacks the funds to stimulate the economy and, for ideological reasons, is unwilling to introduce reforms that might begin the process of economic revival. As a result, analysts have repeatedly pointed to Venezuela’s rapidly deteriorating living conditions and predicted that the government would not survive the year.

So far, Maduro has proved them wrong, using dwindling oil revenues to sustain support from his partisans and — more important — the military. High-ranking officers benefit from government business monopolies, kickbacks, illicit activities like the drug trade, and especially, their control over the country’s (largely imported) food supply.

For the time being, these officers have a vested interest in keeping Maduro in power, since they don’t want to lose their windfalls but don’t want to govern. This fragile equilibrium is unlikely to hold, though, as the government probably lacks the resources to sustain patronage payments to the key players indefinitely. And, as lower level officers don’t get much trickle-down from the patronage, it is easy to imagine them participating in a coup.

Sooner or later, Maduro is likely to see the military aligning with the opposition. Whether the economy will be in decent enough shape to recover after a change of government without the benefit of high oil prices is another question entirely.

Iran

Iran has survived as a regional power, despite off and on sanctions since the 1999 revolution, including the 2012 sanctions that crippled the economy and forced the government to at least temporarily abandon its nuclear ambitions. Ironically, because these sanctions forced Iran to diversify its economy to a much larger extent than the other large OPEC producers, the country appears to be in a better position to muddle through an era of low oil prices.

Since the removal of the nuclear sanctions, Iran has expanded its oil exports to levels the country last enjoyed in the 1970s, as well as received a big chunk of change in the form of funds previously blocked in foreign banks. If the money is invested well in the non-oil sectors, Iran’s economy could prosper and consolidate its leadership of the Shiite Mideast. But this is not a done deal: the economy carries a lot of baggage in the form of powerful constituencies (the military, the mullahs) that would balk at the loss of privileges and have no particular enthusiasm for market-driven resource allocation.

OPEC, RIP?

OPEC has been declared dead before, as oil production capacity periodically surged ahead of global demand. But the shale phenomenon, with growing small-scale production in the United States and potentially in a dozen other countries, appears to have finally closed the door on its ability to significantly affect oil prices.

Thanks to the market power that OPEC wielded until recently, its members have tended to look at price declines from a short-run perspective – to hang on, run down cash reserves to fund government budgets, and to borrow if necessary. Most felt no need to embark on the disruptive task of diversifying their economies or subjecting them to the discipline of free markets since it was assumed that oil prices would save them. The new era has thus left them more exposed to political and economic instability for which they now lack the resources to paper over.

That’s certainly good news from the narrow perspective of oil consumers. One has to wonder, though, whether the woes of the OPEC countries won’t spill over in the form of geopolitical instability. How, for example, the collapse of the governments of Saudi Arabia, Iraq or Venezuela would affect the rest of the world is anyone’s guess. But one thing is certain: it wouldn’t be pretty.

main topic: Energy
related topics: Latin America, Middle East, Russia