Matein Khalid: The Free Fall Of Oil

It is ironic that crude oil fell from $115 a barrel (Brent) last June, when ISIL fighters seized the Iraqi city of Mosul, to $92 a barrel by early October 2014.

Oil has been in a free fall at a time when the West has tightened sanctions on Russian energy and banking despite the Ukraine ceasefire, Nigeria has missed its production targets, and rival militias have seized Libya’s capital.

The collapse in crude oil also reflects the fall in global growth rates, now confirmed by official IMF forecasts. The rise in the US Dollar Index to two-year highs is also highly negative for oil prices as is a European economy where declines in refiner demand have created a glut in North Sea oil.

Most ominously, Saudi Arabia has refused to play its traditional role of swing producer in OPEC. The Kingdom has cut the posted price of its Arabian Light crudes to preserve its market share in Asia and has not even hinted at an output cut.

This is a de facto recognition of the new realities of the global oil market, whose bearish currents now include a surge in US and Canadian shale oil output and a fall in Chinese GDP growth below the Politburo’s official 7.5 per cent target.

Saudi Arabia is China’s leading oil supplier and exports more than a million barrels a day to the People’s Republic.

In a glutted market, the Kingdom knows it will only lose market share to other Middle East producers that are not restrained by OPEC quotas, mainly Iraq. The political violence in Anbar and Nineveh provinces has not impacted Iraq’s production in Basra Province, still above 2.7 million barrels a day.

The rise in the US dollar against the Euro and Japanese yen is a secular trend. So a higher US dollar will continue to pressure crude oil in 2014 and 2015. Goldman Sachs predicts the dollar will rise another 25 per cent in the next two years to parity against the Euro.

This means oil prices will remain under pressure even as the Federal Reserve begins to tighten monetary policy.

China is the world’s largest oil consumer and its economy faces myriad structural challenges. After all, iron ore has fallen 41 per cent in 2014 alone and copper, highly correlated to Chinese construction demand, has fallen to $6500 a tonne on the London Metal Exchange.

The oil market also fears that the discord in OPEC will escalate into a price war. US oil imports have plunged by 60 per cent since 2008, meaning two million barrels of Nigerian and Angolan crude oil is not exported to the US and dumped on the world spot tanker markets.

If Saudi Arabia is not willing to cut production unilaterally, neither will the UAE, Kuwait and Iraq cut back. This means the risk of an OPEC price war are all too real.

Kuwait, which wants to raise output to three million barrels a day, has also reduced its posted price without coordination with OPEC. This is the classic Prisoner’s Dilemma in the mathematical area of game theory.

Only Saudi Arabia, with its low production costs and high production capacity, can enforce a production cut in OPEC.

However, even though the Kingdom budget breakeven price has risen from $65 to $90 a barrel in the past decade, Saudi Arabia is no longer willing to pay the steep financial and diplomatic price of the “swing producer” role it last played in early 2009.

Oil prices fell from $147 a barrel in July 2008 to $40 a barrel in January 2009, after the failure of Lehman Brothers, the ice age in the credit markets and global recession. Saudi Arabia engineered a 4 million barrel a day OPEC output cut that enabled prices to rise back above $100 a barrel in 2010. Will Saudi policy shift again in 2014 if oil prices fall below $85?