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IPE special report May 2018

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IPE Views: The oil price – driven by economics or politics?

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Joseph Mariathasan considers the impossible challenge of predicting the price of oil

It always amuses me when I read analyses of where the oil price is likely to be over the next few years. As a young analyst at Shell International, I can remember working on economic modelling of North Sea oil wells using three oil price scenarios. The then-current price was around $30 a barrel, and the lowest price, worst-case scenario we used was one of $19 a barrel. Six months after I left Shell to join an investment bank, the oil price had dropped to $10 a barrel. If mighty Shell, with all its decades of experience, did not have a clue where prices were likely to be in six months’ time, I find it hard to take anyone else seriously when they come out with forecasts based on supply and demand projections and all the other paraphernalia of financial economics.

The problem with forecasts is that it is politics, not economics, that can have the bigger impact on oil prices. Saudi Arabia’s cost of production is still probably not much more than $6 a barrel, although I am no expert on this. US shale oil production costs, even though they have fallen dramatically, would still be hovering probably close to 10 times that price at $60-$70 a barrel. When oil was trading at well above $100 – which was the case recently until mid-2014 – the US was well on its way to self-sufficiency in oil thanks to the game-changing introduction of fracking.

Yet, if you looked at any other easily tradeable commodity item – T-shirts, for example – no US manufacturer would survive if their cost base were 10 times that of an overseas competitor for an identical product with negligible transport and storage costs, and an indefinite life and pretty much unlimited capacity. But oil, of course, is a strategic commodity, and the US recognised this by launching its own Strategic Petroleum Reserve, which holds enough oil to supply the US for nearly 40 days. It was started in 1975 after the disruption in supplies caused by the 1973 OPEC embargo, itself induced following US support for Israel in the 1973 Yom Kippur war.

Fracking has clearly been a game changer for both the economics and politics of oil. The US attaining self-sufficiency in oil over a long time period would have immense ramifications on US foreign policy towards the Middle East. A big loser would be Saudi Arabia, whose leadership has used the support of the Wahhabi clergy for legitimacy and the wealth it accrued to export this brand of Islam globally.

Whilst US support is clearly still strong, the underlying tensions are obvious. The Saudi Arabian leadership needs US support, but they face a delicate balancing act as they struggle with the tensions inherent in their society. Ensuring US interest and support for their regime becomes a more critical issue when they can see the fall of Egypt’s Muhammad Hosni El Sayed Mubarak despite decades of US support. Guaranteeing support means ultimately ensuring US reliance on Saudi oil, and, to bring such support about, it needs to drive the fracking community out of business.

There are additional benefits to such a close relationship in light of Russia’s recent activity. Russia is heavily dependent on energy exports, which may account for as much as 70% of goods sold overseas. It was the low oil prices in 1990 that contributed to president Mikhail Gorbachev’s struggle to keep the USSR solvent and helped to cause its eventual collapse in December 1991. A low oil price will lead to serious repercussions for an increasingly belligerent Russia under Vladimir Putin, who is also a supporter of Syria’s president and leader of the Shia-related Alawite community, Bashar al-Assad, whom the strictly Sunni Saudis are keen to see replaced. Indeed, some would argue that ‘weaponising’ the oil price in order to try and cause political change in Russia has been a key factor in the oil price collapse. It would certainly be a less destructive route to achieving the US and EU’s foreign policy aims than weaponising the Ukraine through arms sales.

I guess, if I were a betting man, I would say the oil price would be likely to stay below the marginal costs of fracking production for a few years.

Joseph Mariathasan is a contributing editor at IPE

Readers' comments (2)

  • I agree in the main. I see the oil price manipulation as a classic oligopoly squeeze on higher cost producers, yes, but also on alternatives, especially solar, which for the first time was running cheaper in the US than fossil fuels just before the squeeze began. It will moderate when the medium to long term carnage becomes significant.

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  • I don't see much classic free market demand-supply economics in this industry. Demand for oil may be driven by economic fundamentals, but supply certainly isn't. Supply is driven by geo-politics, at least over shorter-term cycles. The political motives of supply-side oil producers may not always be entirely transparent, but the motives are there non-the-less.

    And prices over the past two decades or so? Are they always correlated to demand and supply data as economic theory would suggest? At the same time, what price alternative sources of energy without significant government/political intervention? (Solar, fracking, exploration licenses/pipelines etc.)

    The oil sector is a prime example where there is a real economy, a political economy and global financial markets at work. Understanding how these economies interact is key to understanding how asset price/movements are linked (or disconnected) from fundamentals...in my opinion.

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