Oil Markets and the Arab revolutions

12 April 201111 Minute Read

The uprisings have affected the governments of some of the world's largest oil exporters. In the long-term, however, supply is unlikely to be affected.

By Joshua Ereira for RUSI.org

The recent unrest in the Middle East has been accompanied by a rise in the spot price of Brent Crude, from $95 at the start of the turmoil, to $120.71 as of 06.04.2011.[1] This represents an increase of approximately 20 per cent in the span of six weeks; not unprecedented, but certainly significant.

Despite the resultant shocks sent through both world equity and oil markets, the affected countries at risk represent only about 7 per cent of total world oil output, and it is unlikely that even in a worst-case scenario more than 20 per cent of this production is at significant risk, even in the short term. At the peak of the war in Iraq, for instance, production only fell by 30 per cent, and has since recovered to its pre-war level of around 2.5 MBPD (Million Barrels Per Day).[2] This seems to suggest that the impact of the turmoil on medium- to long-term supply is relatively insignificant, given that OPEC's spare capacity is currently running at around 4-5 MBPD, according to the International Energy Agency (IEA).

As volatile as oil markets are in the short term, in the long term they are driven by the basic forces of supply and demand. Though some blame speculators in oil futures for exacerbating recent spikes, such as the peak of $147 in 2008, their impact has been shown to be relatively small;[3] in times of high volatility and extreme political uncertainty, speculators are unlikely culprits. Most analysts agree that the major trend in global oil demand, driven by the economic ascendancy of, predominantly, Brazil, Russia, India and China, is one of strong growth. The IEA estimates that global oil demand will rise by 6 MBPD by 2015, and it is uncertain if production can keep pace. Output from non-OPEC producers is flattening or decreasing, though OPEC still has room to expand production and will account for about 50 per cent of growth until 2015. The IAE expects production to grow by 5.5 MBPD - though with caveats.

This suggests that oil prices will remain high for the foreseeable future. However, relatively minor supply shocks have lead to disproportionate responses from oil markets in the past, as buyers have scrambled to secure contracts. It is not inconceivable that such an effect may be seen again, given the current uncertain climate, and it is hence important to consider the potential impact of current unrest on global oil supply.

Libya

Libya is the largest oil producer still in the throes of potential revolution. With its estimated production of 1.6 MBPD, Libya supplies around 2 per cent of the world's oil, and is a member of OPEC. Oil supply was disrupted on 10 March when Qadhafi's jets bombed pipelines near Ras Lanuf, driving spot prices over $116 PB. The scale of the damage to the oil infrastructure is not yet clear, and if extensive it may take months or even years to resume full production.[4] During the peak of the crisis, some analysts feared that oil exports from Libya might decline to only 300,000 BPD,[5] due in large part to international economic sanctions imposed on the Qadhafi regime blocking Mediterranean ports from accepting Libyan exports. This scenario looks increasingly unlikely: UN resolution 1973 and strikes on his military have crippled Qadhafi''s ability to maintain full control of the country's oil production, and the coalition's stated intention of supporting the opposition will likely include accepting oil exports from areas they control. Nonetheless, during the height of the conflict the oil price closely tracked the severity of the clashes. On 16 February, at the start of major protests in Libya's second largest city, Benghazi, spot prices for Brent Crude were hovering around $98 per barrel. As the conflict intensified, prices rose steadily, due in part to supply disruptions, reaching $112 on 27 February. Since then, prices have been fluctuating violently, peaking at $120. [6]

There is much uncertainty regarding the future of the country. This not only relates to the potential for a drawn-out conflict in which Gadaffi clings to power amid sanctions and armed opposition, but also potential problems related to an opposition victory. The battle rages on: the city of Bin Jawad has been captured three times in the last month,[7] and the opposing forces are locked in a see-saw battle. The NATO coalition will likely have to arm the opposition in order for them to win a victory with any alacrity, though whether or not they will actually do this is uncertain. Even in the case of a clear opposition victory, the unpredictability of a highly fractious, tribal society experiencing a sudden power vacuum is also of concern. For one, the West knows very little about the groups set to take power in the transition and its aftermath, and there is no guarantee that further infighting will not occur, nor that the government will be as friendly to the West as the optimists expect. In this scenario, conflict over oil resources would be central, and longer-term disruptions to supply might potentially occur, putting further upward pressure on prices. However, it seems most likely that any long-term impact on exports from Libya will be relatively marginal.

Yemen

Yemen is a relatively minor oil producer, with production in 2009 running at around 300,000 BPD.[8] More importantly, its output is forecast to decline steadily year-on-year to negligible levels by 2017, barring miraculous discoveries of new oil fields (IEA), when reserves are expected to be depleted. This may lead to economic collapse and social turmoil on an even greater scale than the current unrest.

On the 10 March, President Ali Abdullah Saleh pledged reforms to create a parliamentary system, and ten days later he sacked his cabinet. Neither move noticeably mollified the protestors, hundreds of whom were killed during the protests. Several military commanders have resigned, and on 23 March the President declared martial law and suspended the constitution. The revolt continues to spread, with no end in sight, and the outlook for the future is fraught with uncertainty. As such, major supply disruptions already taking place are likely to continue, though as the expected decline of Yemeni oil production is probably already priced into futures markets, this is unlikely to have a large effect on prices.

Syria

According to Reuters, in 2010 Syria produced a relatively modest 386,000 BPD, up 2 per cent from 2009 but still lower than the peak in 1995.[9] Most of the large oil fields are concentrated in the east, at this point relatively far from the heaviest conflict, though this may soon change. The unrest began in force in the southern city of Deraa. By 29 March, in the wake of government reprisals which left hundreds dead and failed to stem the demonstrations, President Assad sacked his cabinet. Protests in the north and in the capital of Damascus currently continue unabated. The situation is certainly unstable, but the demonstrators lack the resources and organisation seen in Libya, and as of yet the government response has not reached the levels of severity seen there. The situation is nonetheless highly volatile and unpredictable.

In terms of its impact on oil markets, the effect is relatively muted. Not only are the oil fields still producing, but the low levels of exports from Syria relative to world markets is too slight to have a significant impact on spot prices.

Bahrain

Bahrain's oil production - just shy of 50,000 BPD - is hardly significant in global terms. Yet the unrest in this small island nation has oil markets watching very carefully, due to the potential implications of unrest in Bahrain spreading to neighbouring Saudi Arabia. Bahrain's ruling family, the Khalifa dynasty, are Sunni Muslims, a privileged minority making up approximately 30 per cent of the Muslim population. Shiites make up the remaining 70 per cent.[10] The Khalifa dynasty maintain close ties with the House of Saud, who on 14 March sent troops and Armoured Personnel Carriers across the Saudi-built causeway linking the two kingdoms to bolster the government.

This move was believed to have been motivated by fears of the contagion sweeping across northern Africa and the Middle East having the potential to also break out in Shiite areas of Saudi Arabia. Though Saudi Arabia's ruling Sunnis are in an 85-90 per cent majority over the Shiites, the latter are over-represented in the oil-rich eastern regions around the massive Ghawar oil field, which produces around 5 MBPD (more than any single country save the US and Russia). The worry is that discontent may spread from Bahrain's Shiites to their Saudi counterparts only hours away by car. Indeed, small protests have already erupted in this region, though not yet on a worrying scale. The terrifying havoc that disruptions to the Ghawar oil fields would wreak on oil markets, and consequently the global economy, makes events here of critical importance.

Not only does the region supply close to 10 per cent of the world's oil at current extraction rates, it also represents anywhere from 50-80 per cent of the world's spare capacity, though there is much disagreement about the details.[11] The loss of this capacity would make oil markets unable to absorb the supply disruptions already in effect due to the crisis. Its impact would multiply exponentially, making speculation as to the upper limits of price moves under this worst-case scenario almost futile. This would be unprecedented, with only the oil crisis and embargo of the seventies of comparable import. We would likely see at least the collapse of futures and other oil-related derivatives markets, as contracts spiral in value. The knock-on effects of this are all-too-familiar and ominous in a world still reeling from the credit crisis and the near-collapse of the sub-prime derivatives markets. It is highly unlikely that the global community would allow anything of this scale to occur, but even the fear of minor disruptions is enough to worry analysts.

Conclusion

A number of other countries have also been affected by the recent wave of demonstrations, Algeria and Iran key among them. In the former, an OPEC member with significant production of around 1.4 MBPD,[12] things seem to have quieted down for the time being. In the latter, immediate crackdowns by the regime have so far stopped the demonstrations from developing into anything resembling those of last year. But both situations will no doubt be monitored closely by analysts and commentators as the overall picture in the region continues to be dominated by instability. Developments in Egypt, where the transition to a new government is now taking place, are also of interest. Egypt is not a major oil producer, but its control of shipping through the Suez Canal means that the international community has a large stake in its future, both politically - especially in terms of relations with Israel - and economically, for oil markets and other trade.

On the positive side, Iraqi oil production is increasing rapidly in its new-found, relatively stable political situation. Some analysts see its output doubling or even tripling by 2015,[13] to 5 or 7.5 MBP. This would go a long way towards offsetting any medium-term shortfalls in production from the current crisis.

Another issue worth noting is that Saudi Arabia and OPEC may be more resistant to increasing supply now than during the peak in 2008. The instability now engulfing the Middle East is causing several governments to attempt to appease their citizens with increased spending: Saudi King Abdullah, for instance, unveiled a benefits package worth between $35 and $38 billion on 23 February [14] in an attempt to mollify critics. Cash-strapped governments may therefore be tempted to accept higher oil prices in the short term, though long-term fears about high prices leading to quicker worldwide adoption of alternative energy sources should ultimately prevail in the medium- to long-term. Governments may also attempt increase pressure on foreign operators to return a larger share of profits to them. However, any such financial aid to unpopular regimes in the region, especially in the case of Western operators, may be politically unpalatable at home.

In terms of the likelihood of major long-term supply disruptions, oil markets may be over-reacting to the current unrest. Futures contracts are currently trading at only a small premium on spot prices of around $2.50, suggesting that the current spike is running out of steam. In the short term, however, the global political picture looks to continue to be a substantial driver of prices and volatility.

Photo courtesy of Dennis Sylvester Hurd