Stakes high as US plays oil card

Spells rouble: The Russian currency fell 10% last week but lower oil prices will also add to the cost of fracking. Photo: Vasily Maximov/AFP

Spells rouble: The Russian currency fell 10% last week but lower oil prices will also add to the cost of fracking. Photo: Vasily Maximov/AFP

Imagine that at the start of 2014 you were an investor who liked to dabble in the commodity markets. You could sniff something going seriously wrong in Ukraine and you were alarmed by early reports of militants marauding across northern and western Iraq. With hopes that the global economy would continue to strengthen, the smart money would have been on oil prices continuing to climb.

But the smart money was wrong. After standing at more than $110 a barrel earlier in the year, the cost of crude has collapsed. Prices are down by a quarter in the past three months. More oil has been pumped at a time when global recovery has faltered, with traders caught unawares by the slowdown in China and renewed stagnation in the eurozone.

That, though, is not the whole story. The fourfold increase in oil prices triggered by the embargo on exports organised by Saudi Arabia in response to the Yom Kippur War in 1973 showed how crude could be used as a diplomatic and economic weapon. History is repeating itself.

Think about how the Obama administration sees the state of the world. It wants Tehran to come to heel over its nuclear programme. It wants Russian President Vladimir Putin to back off in eastern Ukraine.

But after recent experiences in Iraq and Afghanistan, the White House has no desire to put American boots on the ground. Instead, with the help of its Saudi ally, Washington is trying to drive down the oil price by flooding an already weak market with crude. As the Russians and the Iranians are heavily dependent on oil exports, the assumption is that they will become easier to deal with.

John Kerry, the United States secretary of state, allegedly struck a deal with King Abdullah in September under which the Saudis would sell crude at below the prevailing market price. That would help to explain why the price has been falling at a time when, given the turmoil in Iraq and Syria caused by the Islamic State, it would normally have been rising.

Arab Spring
Turning on the oil spigots comes at a cost. The Saudis, like all other producers, have become accustomed to oil being above $100 a barrel. The Arab Spring in Libya and Egypt raised fears that the political unrest would spread. Oil revenues financed higher public spending, so Saudi Arabia needs the price to be above $90 a barrel to balance the books.

But a bit of pain is acceptable. The Saudis are gambling that they can live with a lower oil price for longer than the Russians and the Iranians can, and that the operation will be relatively short-lived.

Oil and gas account for 70% of Russia’s exports and the budget doesn’t add up unless the oil price is above $100 a barrel. Moscow has foreign exchange reserves, but these are not unlimited. The rouble fell by 10% last week. That adds to the debt servicing costs of Russian firms. The central bank is under pressure to push up interest rates, which should help to stabilise the currency, but only at the expense of a deeper recession.

But thus far, Russia’s foreign policy does not appear to have been affected. Support for President Bashar al-Assad of Syria remains strong and there were reports at the end of last week of Russian troops entering eastern Ukraine. It remains to be seen how Iran will react.

Provided it is sustained, a falling oil price will boost global growth. Andrew Kenningham at Capital Economics estimates that, if the cost of Brent crude settles at $85 a barrel, the upshot will be a transfer of income from producers of oil to consumers of oil amounting to 0.9% of global gross domestic product. The big winners will be the big oil consumers: China, India and Europe.

Inflation will also fall. The drop in the oil price so far is enough to ensure that headline inflation will be about half a percentage point lower in advanced countries next year. Lower inflation should help to boost consumer and business spending because budgets will stretch further.

For the US, the picture is more mixed. Its willingness to play the oil card stems from the belief that domestic supplies from fracking make it possible for it to become the world’s biggest oil producer.

Recent US production of crude has been impressive, with a jump of almost 50% from 5.7-million barrels a day in 2011 to 8.4-million barrels a day in the second quarter of 2014. This has meant that any reduction in supplies from Iran or Russia because of sanctions can be absorbed without disrupting the global economy.

But the sharp drop in the oil price will make some shale fields unviable, particularly new developments, where a high price is needed to cover start-up costs.

This is also true of some of the more mature fields, where the rapid depletion of reserves has forced companies to go deeper, at greater expense, in search of supplies. – © Guardian News & Media 2014



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