RealClearWorld Newsletters: Mideast Memo
Making Sense of the Mideast Oil Muddle
Analysts often speak in generalities when discussing the relationship between oil and the Middle East. While the all-important commodity is widely understood to be the lifeblood of many, if not most, governments across the region, we often have a shallow understanding of just how important oil is to the Mideast, especially during this era of upheaval and low prices per barrel.
Low oil prices don't just affect the wealthy sheiks of the Gulf, but also the Kurdish peshmerga fighters operating on the front line against the Islamic State group. With the decline in market value comes a decline in oil exploration, and diminished budgetary expectations in countries like Iraq that are already hanging on by a thread. Oil profits have long enabled governments such as Saudi Arabia's to lavish their citizens with cheap gasoline and subsidized goods. Those days now appear to be coming to an end.
This week, the Memo asked RealClearEnergy editor Bill Murray to help make sense of the unpredictable oil market, and how its current state of flux is affecting the Middle East.
RCW: Oil prices and domestic policy often seem to go hand in hand in the Middle East. How are low oil prices changing the behavior of actors and states in the Middle East? Have you noticed a difference?
Murray: The short answer is not yet. Granted, the region's oil exporters are girding for some long-term budget pain as the low oil price environment looks set to continue. The Gulf nations of Kuwait, Qatar, and the United Arab Emirates had 2015 break-even oil prices necessary to balance their government budgets of $54, $60, and $77 a barrel respectively, well above the current $35 to $40 a barrel range. The public finances outlook for Saudi Arabia is even worse, since their budget break-even is about $100 a barrel. It's worth remembering, however, that each of these countries have hundreds of billions of dollars in savings in the form of short-term debt, cash, and sovereign-wealth funds that can be drawn on for years to come, so a major change in political behavior has not yet been observable.
RCW: Oil prices dipped again this week on the news that Iran would not participate in the oil freeze proposed by large producers last month. Saudi Arabia, moreover, continues to pump oil apace in spite of last month's agreement. What's going on here?
Murray: Saudi Arabia is just sticking to its strategy, initiated back in November 2014, to overwhelm the oil market with supply as a way to flush out higher-cost U.S. shale producers and protect its market share in Asia from fellow OPEC members. The Saudis last behaved this way in 1986 after the kingdom got tired of losing customers to OPEC members who were fibbing about their production levels. This, in turn, caused the fortunes of non-OPEC producers in the North Sea, Alaska, and throughout North America to collapse. Now, the Saudis hope to emulate a more successful 1998-1999 agreement between OPEC and non-OPEC members, including Mexico and Norway, that cut production in order to bring prices off a $10-a-barrel floor. The current production freeze agreement caveat -- that all large producers must first participate -- is large enough to drive an Iranian supertanker through, making it much less likely to work in the near-term.
RCW: Throughout much of the current oil supply glut, conventional wisdom has dictated that Saudi Arabia is using low oil prices to increase capacity and maintain market share -- refusing to be the "swing producer," as this author put it. But the kingdom is doing all of this amid a costly war in Yemen, and it is reportedly preparing to incur an uncharacteristically large amount of debt to meet budgetary demands.
All of this might strike the casual observer as a little crazy. What does Riyadh know that we do not?
Murray: While unusual, Riyadh's current fiscal predicament is not without precedent. Again, the Saudi crown has about $600 billion in sovereign wealth to spend before it runs out of cash. Oil prices would have to stay low for four to five years in order to drain those accounts, and as we are seeing, the period of under-investment currently taking place in the oil patch simply sows the seeds of the next price rebound.
Back in 1999, when oil prices were averaging $18 a barrel, Saudi Arabia's sovereign debt was over 100 percent of its Gross Domestic Product (GDP). Now, after more than a decade of massive rentier earnings, its debt-to-GDP ratio is 1.6 percent. Meanwhile, the kingdom's GDP rose from about $180 billion in 1999 to $746 billion in 2014 in constant dollars. That said, these massive profits just underscore how finished the oil bull market is for years to come. The Saudi budget deficit reached $100 billion last year, and the invitation to banks for a $6 billion to $8 billion loan represented the right time to get its sovereign debt rated in case the "lower for longer" oil price thesis plays out.
RCW: Kuwait announced earlier this month that it intends to change the way it prices its oil in order to be more competitive in markets such as Europe. Can you briefly explain these different pricing metrics, and why they matter to Mideast countries looking to sell their oil?
Murray: Given the current low oil price, Mideast producers are desperate to sell more to Europe. Kuwait's decision to link sales of its European exports to the dated Brent benchmark gives it a price advantage over similar Saudi and Iranian crudes, which are priced using BWAVE, a volume-weighted average of a day's trade based on a Brent futures price. Brent is the benchmark crude from the North Sea that is the yardstick by which 70 percent of the world's oil is priced.
Because so much oil is sloshing around the world's oceans in supertankers at the moment, spot prices -- those physical cargoes that are available on a delivery ‘date' -- are priced more cheaply than cargoes with prices derived from a futures market. Both Iraqi and Kurdish crudes are being sold in Europe using dated Brent prices, sometimes at deep discounts, and Kuwait is simply adjusting to the marketplace.
RCW: The press pays a good deal of attention to the price of oil, but not nearly as much to capital costs and oil exploration. How does this vary from country to country?
Murray: There are two types of oil companies: those owned by private individuals or masses of shareholders, and those run by state-owned companies ultimately controlled by national governments. The differences between the two are very large in terms of how they invest to explore and produce oil.
For publicly traded international super-majors, such as ExxonMobil and Royal Dutch Shell, these companies spend tens of billions of dollars a year searching for and developing oil and gas around the world, and they answer to shareholders each quarter since they are traded on public exchanges. Additionally, there are thousands of smaller companies operating in the tight oil plays of North America -- these are the cultural inheritors of the original "wildcatters" of the early 20th Century -- who must impress investors, typically hedge funds and investment banks, with their stories of potential riches to get credit lines and sell their production forward with hedging strategies that demand they produce oil and gas regardless of the current oil price. Such dynamics are why it took so long for U.S. production to decline from its peak of 9.6 million barrels per day in June 2015 to its current 9.1 million barrels per day in March 2016.
In the Mideast, it's all about the national oil companies, or NOCs, that have a near monopoly over their country's resources. For Saudi Arabia, it's Saudi Aramco. In Iran, it's the National Iranian Oil Company. For Kuwait, it's the Kuwait Petroleum Corporation, and many other countries outside the Middle East -- such as Brazil, Venezuela, Norway, and Malaysia -- also have NOCs. To differing degrees, these companies are auxiliary, for-profit units of the national government, sending billions of dollars annually into their nation's treasuries from oil production. The way each NOC operates regarding exploration is specific to each country, but many contract with major Western oil companies and oil-service firms using a version of a Production Sharing Agreement service contract first popularized in the 1960s. These agreements allow private firms to recover their capital and operational expenditures first and split the profits with the NOC afterward, thus putting most of the business risk onto the private companies. The NOC structure allows a state-owned company to operate in the marketplace and still give the national government overall control of its direction.
RCW: Where does the Iraqi oil industry stand? Why is Baghdad renegotiating its oil contracts with foreign oil companies, and what will this mean for the Iraqi economy going forward?
Murray: The Iraqi oil industry finally had its long-promised "golden-year" in 2015 when it added 700,000 barrels a day of production and exited the year producing 4.2 million barrels a day of crude, breaking an output record set way back in 1979. But the going will only get harder over the next several years as $30 to $40 oil, coupled with the costs of fighting the Islamic State group, have undermined Baghdad's ability to reimburse foreign oil companies that are owed billions of dollars in reimbursements.
The international oil companies involved in Iraq's southern oil fields -- BP, Shell, Exxon, Eni, and Lukoil -- operate under service contracts that pay a fixed dollar price for each additional barrel, regardless of the oil price. Such an arrangement means Baghdad will have to renegotiate with the oil companies and continue a policy of "muddling through" that has become synonymous with Iraqi oil development.
Saudi Arabia's Destructive Oil Freeze -- Foreign Policy
Saudis Seek $6 to $8 Billion Bank Loan -- Reuters
Iraq Prepares to Amend Its Oil Contracts -- Al-Monitor
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