The United States has just passed Saudi Arabia as the world’s largest producer of oil. The USA passed the Russians, who were in second place, a few months ago. This is a momentous global political and economic event which will have vast implications. The increase in US domestic oil production has been due entirely to the development of fracking for shale oil, which has added 5 million barrels of oil per day since 2008. The rise in U.S. crude output has simply been explosive. America added 1.6 million barrels a day in 2014, taking production past its previous peak in 1970. This surge in fracked oil production production means that USA is now providing 90 percent of its demand for oil domestically, something that hasn’t occurred since 1984. At the low point around 2005, the USA were only producing 70 percent of its consumption and the trend seemed to be inevitably downward until the fracking industry developed.
This move to almost self sufficiency in oil in the USA combined with China’s slowing economy meant 2014 saw energy consumption grow just 2.6 percent, less than half its recent average and the smallest increase since the Asian crisis of 1998. China’s energy intensity, the amount of fuel it needs to consume to generate each dollar of GDP, is getting closer to U.S. and European levels.
These shifts in the economics of global oil, new fracked oil production and changing patterns of consumption, has caused the price of oil to plummet. For about three and half years from 2010 the price largely remained in the $90–$120 range. In the middle of 2014, price started declining and by January 2015 the price of benchmark crude oil, both Brent and West Texas Intermediate, reached below $50.
The contract price of US crude oil for delivery in December 2020 is currently $62.05 in the oil futures market, this implies big and drastic long term changes economic landscape for the Middle East and what might be called the petro-rentier states.
If the oil futures market is correct, Saudi Arabia is going to face a very difficult financial future with mounting budget deficits, or destabilising austerity, or a combination of both.
Last November Saudi Arabia took a huge gamble when they stopped supporting oil prices and opted instead to flood the market by boosting their own output to 10.6 million barrels a day in an attempt to stop the fracking industry by causing oil prices to drop. One result of that unilateral action was that OPEC ceased to exist in any meaningful way.
The Saudi aim was to choke the US shale industry but it appears the Saudis have misjudged badly, just as they misjudged the growing shale threat at every stage for eight years. “It is becoming apparent that non-OPEC producers are not as responsive to low oil prices as had been thought, at least in the short-run,” said the Saudi central bank in its latest stability report. “The main impact has been to cut back on developmental drilling of new oil wells, rather than slowing the flow of oil from existing wells. This requires more patience,” it said. In reality the Saudi anti-fracking strategy hasn’t worked and will never work.
The Saudi strategy of actively trying to crash the global oil price to render the fracking extraction in the US uneconomic has actually killed off a raft of high-cost oil ventures in the Russian Arctic, the Gulf of Mexico, the deep waters of the mid-Atlantic, and the Canadian tar sands. It is estimated that as result of the drop in price the major oil and gas companies have shelved 46 large projects, deferring $200 billion of investments. But the problem for the Saudis is that US shale frackers are not high-cost. They are mostly mid-cost, and the shale companies think they may be able to shave those costs by 45% this year, and not only by switching tactically to high-yielding wells. Advanced pad drilling techniques allow frackers to launch five or ten wells in different directions from the same site, smart drill-bits with computer chips can seek out cracks in the rock and new dissolvable plugs promise to save $300,000 a well. The drop in oil price has reduced the pace of new fracking but the industry as a whole seems to be comfortably riding the new price environment. The North American fracking rig-count has dropped to 664 from 1,608 in October but output still rose to a forty three year high for the US of 9.6 million barrels a day in June. The history of sister industry of shale gas should be a cautionary warning to those reading too much into falling or stalled rig-count. Gas prices have collapsed from $8 to $2.78 since 2009, and the number of gas rigs has dropped 1,200 to 209. Yet output has risen by 30% over that period.
Given the slowing of demand resulting from a probable slow down in Chinese growth rates and the ability of the US shale industry to both survive lower oil prices and ramp production up rapidly if prices rise it is possible that the price of oil will remain low for quite sometime. And if that is the case then it profoundly affects the economic outlook of a number of countries that are heavily dependent on oil income, not least Saudi Arabia.
| Country | Estimated oil price required to balance 2015 budget |
|---|---|
| Norway | $40 |
| Kuwait | $54 |
| Abu Dhabi | $55 |
| Russia | $105 |
| Saudi Arabia | $106 |
| Nigeria | $122 |
| Iran | $131 |
| Algeria | $131 |
| Venezuela | $160 |
Looking at the data in the table above it is clear that a sustained period of low oil prices will put immense strain on the public finances of a number of oil producing countries. Those most at risk of significant financial disruption include Nigeria, Russia, Iran, Algeria, Venezuela and Saudi Arabia. Russia is also facing the impact of western sanctions and a collapsing currency but in the short term it is Venezuela which has suffered the worst early affects because the economy was already in a shambles when oil was at $120 per barrel, and it’s now spinning out of control as a result of rampant corruption, woeful mismanagement, and collapsing oil revenues. President Nicolas Maduro has responded by blaming the dire situation on a US led international conspiracy and ramping up repression of critics and opposition politicians.
But the long term effect of lower oil prices on Saudi Arabia could also be very significant. Far from retrenching, King Salman is spraying money around, giving away $32 billion in a coronation bonus for all workers and pensioners. Saudi citizens pay no income tax and no interest on personal loans. Subsidised petrol costs twelve cents a litre at the pump. Electricity is given away for 1.3 cents a kilowatt-hour. Spending on patronage exploded after the Arab Spring as the kingdom sought to smother dissent. The Saudis have launched a costly war against the Houthis in Yemen and are engaged in a massive military build-up, entirely reliant on imported weapons, that will propel Saudi Arabia to fifth place in the world defence ranking. The Saudi royal family is leading the Sunni cause against a resurgent Iran, battling for dominance in a bitter struggle between Sunni and Shia across the Middle East. In theory Saudi Arabia can survive low oil prices for many years due to its large foreign exchange reserves. However, it is easier said than done because Saudi Arabai did not use its decades of oil revenues to economically develop the country, instead fearing instability that such modernisation would create the ruling elite froze social development and more or less put the entire country on a very generous social welfare program. A recent Harvard report showed that that Saudi Arabia would have an extra trillion of assets by now if it had adopted the Norwegian model of a sovereign wealth fund to recyle the money instead of treating it as a piggy bank for the finance ministry. The report has caused storm in Riyadh. The result is that it is very difficult for the government to significantly cut welfare schemes and spending without causing destabilising social tensions. Saudi Arabia is already facing a problem of high unemployment, although no official figures are available.
At the same time Saudi Arabia is the main financier of the sectarian war that is raging across the entire middle east (some are comparing this conflict to Europe’s Thirty Year war). “Right now, the Saudis have only one thing on their mind and that is the Iranians. They have a very serious problem. Iranian proxies are running Yemen, Syria, Iraq, and Lebanon,” said Jim Woolsey, the former head of the US Central Intelligence Agency.
The International Monetary Fund estimates that the budget deficit will reach 20% of GDP this year, or roughly $140 billion. Earlier this year, ratings agency Standard & Poor’s cut Saudi Arabia’s rating to negative and warned that the country could face a “sustained” budget deficit in the face of falling oil prices.
Money began to leak out of Saudi Arabia after the Arab Spring, with net capital outflows reaching 8% of GDP annually even before the oil price crash. The country has since been burning through its foreign reserves at a vertiginous pace. The reserves peaked at $737 billion in August of 2014. They dropped to $672 billion in May. At current prices they are falling by at least $12 billion a month. The Saudi buffer is not particularly large given the country’s fixed exchange system. Kuwait, Qatar, and Abu Dhabi all have three times greater reserves per capita. If sustained the current rate of draw down would mean Saudi reserves may be down to $200 billion by the end of 2018. The markets will react long before this, seeing the writing on the wall. Capital flight would accelerate.
The Saudi response has been to maintain spending and borrow money to ease the drain on its reserves. Saudi Arabia is returning to the bond market with a plan to raise $27 billion by the end of the year and the Saudi central bank has been sounding out demand for an issuance of about $5.3 billion a month in bonds, in tranches of five, seven and 10 years, for the rest of the year. Fahad al-Mubarak, the governor of the Saudi Arabian Monetary Agency, said in July that Riyadh had already issued its first $4 billion in local bonds, the first sovereign issuance since 2007. The plan to resort to capital markets demonstrates the priority Riyadh is placing on maintaining government spending, despite the pressure cheap oil is putting on its budget. The bond plan has echoes of the 1990s, when Riyadh issued local banking debt via Saudi government development bonds. At one point at the end of the 1990s, Saudi debt reached 100 per cent of gross domestic product. It was only when oil prices began their sharp ascent in the early 2000s that Saudi debt levels began to come down. In the context of the changed global oil market conditions since the development of fracking it is not clear how much the international financial system will loan to Saudi Arabia, against collateral consisting of an estimated value for the oil in the ground.
This time the oil market situation is very different compared to the last time the Saudi’s ran a deficit, back in the 1990s oil prices were depressed by economic contraction in Japan and Asia, this time there is a contraction of demand because of a slow down in China but in addition there is the big new factor of the shale oil industry. The frackers can maintain production during periods of low prices and ramp up production if prices rise. So even if the Saudis could do a deal with Russia and orchestrate a cut in output to boost prices, they might merely gain a few more years of high income at the cost of bringing forward more shale production later on. The dynamics of the global oil economy have fundamentally shifted.
Social spending is the glue that holds together a medieval Wahhabi regime together and although the government can slash infrastructural investment spending for a while, as it did in the mid-1980s, in the end it may face an intensely destabilising and sustained period of austerity. With oil prices low Saudi Arabia cannot afford to prop up Egypt, ramp up military spending, maintain a massive welfare state at home and maintain an exorbitant political patronage machine across the Sunni world all at the same time. Something has to give.
