Guns of August: Political risk blowback

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of PLC.

Once Saudi Arabia and Russia eventually run out of oil the 'political no hopers' of today will need to become the major producers of tomorrow, bringing with them a whole new political risk cycle that Europe will come to regret, argues Matthew Hulbert, lead columnist at the European Energy Review.

This op-ed was sent to EURACTIV by Matthew Hulbert, lead columnist at the European Energy Review.

"August 2011 will be memorable in the energy world for a number of reasons. Syria is being pushed to the edge; Gadaffi has fallen; Statoil found major new North Sea reserves, while GDF-Suez struck an impressive €2.9bn memorandum of understanding with China Investment Corporation.

The Trans-Adriatic Pipeline consortium stole some tentative Greek ground over competing Southern Corridor schemes; even ExxonMobil came out of its shell to sign a €3.2bn Arctic deal with Rosneft. Quite a collection – even for the usual rough and tumble of the energy world.

But what's far more interesting, and far more significant, is what didn't (quite) happen: a major oil price correction. That was the lint required to light the powder keg sitting under world energy markets. It would also have revealed deep-seated contradictions between price and politics in the global energy system today. When one goes; the other kicks in. 

By 'major correction' of course we mean larger than the $10 (or so) intraday swings on Brent that came hot on the heels of US downgrades and Europe sinking deeper into a self-dug eurozone hole. What we are really talking about (for now) is Brent dipping to around $80/b – and doing so for some time to come.

Such a figure would have been deemed heretical thinking a couple of months ago, but with Brent momentarily falling below $100/b in mid-August, bearish storm clouds are gathering fast for fundamentals. And it's speed that's the key factor here – when the speculative froth evaporates from the market, it will do so very quickly, with absolutely no guarantees that prices will necessarily settle at $80/b – the supposed 'marginal cost' of production.

Producer states will be caught seriously short if this happens; and if anything, we could see the political paradox emerging where the only thing left underpinning prices is heightened instability across producer states rather than conventional supply restraint.

'Cyclical' could thus take on a whole new definition in the energy world as far price and political instability is concerned – the lower the price, the greater the instability; oil supplies will tighten as a result. Farfetched perhaps, but we at least have to consider whether we have a self correcting 'political risk' mechanism embedded in oil? And if so, which states are merely dispensable cogs designed to turn the wheel, and who gets to benefit from the 'system' as a whole?

Interesting questions, awkward answers – particularly as Saudi Arabia and Russia sit at the apex of the oil world. 

Market déjà-vu?

The parallels with 2008 are of course plain to see: we have booming commodity markets in the midst of financial and economic meltdown. But unlike 2008 when it was assumed that sovereign balance sheets could support private sector calamities, things are so much worse this time around, precisely because it's the solvency of the ECB and the Fed that markets are directly testing.

There is no lender of last resort and no safety net to fall back on, well none that can be provided by anyone other than the Chinese Communist Party, who have their own domestic problems to attend to without soaking up any more US debt. We all know what should happen for global rebalancing to occur (a brief glance at any G8 or G20 communiqué can tell you that) but we also know how that plays out: the G2 of the US and China merely becomes a microcosm for consumer-export divides and surplus-deficit schisms across the board. Little substantive progress has – or will – be made.    

This points towards the strong short-term likelihood of price corrections pinned to weak fundamentals. Demand is highly unlikely to be structurally fixed any time soon; those commercially long on oil have started positioning themselves accordingly if initial 'managed money trader' sell-offs are much to go by on ICE.

Cheaper oil will come as welcome respite for OECD and non-OECD consumers alike, but it's the speed of such corrections that should provide sobering food for thought for producers. Oil markets fleetingly went into free fall in August once the gaps between paper prices and physical realities started to look a little steep – they will look even steeper as the euro lunges from crisis to crisis, the US fails to get its policy act together and inflationary pressures start to tell in Asia.

Yet what's perhaps more incredible than oil hitting $127/b in April, a figure which was never really grounded in market realities, is that producer states – just like 2008 – have fallen for their own press again. Producers have overextended their positions, got greedy and left themselves exposed. They are now facing the very real prospect of oil significantly under $100/b.

That will see Russia out of the money, Central Asian budgets rapidly denuded, and more importantly, uncomfortable price ranges for the bulk of MENA and West African producers to live with. Latin America is in no better, either in Venezuela, Bolivia or Ecuador. Not to mention Mexico.

With everyone precariously balanced at $100/b, the standard question then posed is where will the Saudis set the floor, with Chinese demand providing some protective varnish? Given the difficulties Riyadh will face until its dynastic politics are put on a more sustainable footing, answers remain considerably more uncertain than they did in 2008.

Saudi Arabia has already pledged $129bn in non-discretionary spending measures over the next few years, and although petrodollars have staged a remarkable comeback since 2008/9, most Arab states haven't had the political luxury of saving such funds for a rainy 'counter-cyclical day'.

OPEC is hardly going to step into the breach either. The cartel is in total disarray, with members likely to plump for volume over price to rake in as many dollars as possible. That applies as much to Kuwait, UAE and Qatar as it does to Venezuela, Algeria and Iran right now.

'Cash rich' is a relative term, even for the Gulf monarchies. Should rapid corrections take hold, it won't be long before we start considering which producers constitute the low hanging political fruit for further discontent and unrest. In effect, our 'political risk mechanism' cogs will start turning.  

Loop the loop

And that's the interesting point here – if traditional methods used to set price floors are looking remarkably creaky, what does 'plan B' look like? Not just in terms of how low the price can go (the world is slowly getting used to the fact that volatility is the new norm given 250% price swings in the past two years), but more importantly, how long for before a realistic price band could be re-established to shore up producer states?

Some will say that there is no need to panic. Sure, budgets will have to be trimmed and spending cut a touch, but given a 'marginal' cost of production around $80/b, prices will not dare plunge below such levels. That's a nice piece of economic theory that might (or might not) have credence.

But if we accept that oil at $127/b was something of a speculative bubble, then prices will almost certainly overshoot on the downside once investors exit positions and release liquidity. Like 2008, it will be about keeping investors in the black, not ensuring global oil production (and investment) remains on the straight and narrow.  

The $80/b 'floor assumption' is what's so dangerous for producers. 'Imperfect markets' are more than capable of creating political casualties as prices correct, particularly if we consider that most producers have been struggling to survive at $125/b, let alone the prospect of $50/b as tillers run dry and populations grow restive.

If our hunch between depressed prices and political panic is correct, it's entirely possible that the flat price of crude will be influenced more by political unrest clipping production, rather than active supply restraint.

Libya arguably serves as a case in point. Once the Arab Spring spread to Tripoli a 2% global outage translated to a 30% increase in benchmark prices. Conversely, as soon as it appeared Gaddafi was finally to be ousted, the mere prospect of Libyan output trickling back online prompted a $4 drop in Brent prices.

That's simple knee-jerk market reaction stuff, but the logic is at least clear: if key producers go offline, prices typically firm. What's more, they tend to stay offline for some time once things go awry. Libya is highly unlikely to return to pumping 1.6mb/d anytime soon; production will flat-line under 600,000b/d.

Depending on how transitional politics play out, keeping its seat at the OPEC table will be hard going. Egypt had exactly the same bullish price effects, both in terms of lost production and supply chain insecurities linked to the Suez Canal and Red Sea.

Such examples obviously relate to political risk driving prices up at the top of the market, but if we think about it, political instability has also been underpinning the market for some time now closer to the bottom.

Iraqi production levels have never recovered to 1990 levels, nor have they in Iran, where production peaked in 1979. Both nations only account for 3% of 5% of global production despite sitting on 10% or so of global reserves each.

Venezuelais a similar story; proven probable reserves continue to go up and up, while production remains stuck below 2002-3 levels. Nigeria output has been stymied by civil war and corruption throughout the 2000s; while a raft of smaller producers have persistently underperformed from sharpened resource nationalism and creeping instability.   

Start putting these kinds of reserves online and prices would clearly be more depressed than they are today. Admittedly, political insecurities in such states have not been driven (or at least not exclusively) by oil price volatility, but persistent resource (mis)-management has hardly helped. With the Arab Spring morphing into a Libyan Summer, producers are more exposed than ever to softening prices and increased political crisis.

This is where outages are mostly likely to come. Take the likes of Yemen, Bahrain and Syria. On their own, all relatively small, but combined, collectively amount to around 1mb/d of production. Few analysts would bet against further political turmoil in these states, especially if Saleh, Khalifa and Assad have even fewer petrodollars to fall back on. That's clearly bad news for them, but not necessarily bad for the oil world per se given the Catch 22 producers are in.

Goldilocks formula

What we are basically tabling here is the twisted logic that stability is increasingly bad news for oil producing states. What you really want as a producer when prices soften is heightened instability in other producer regimes to ignite, helping to set a supply-side floor while free-riding on the economic gains.

And if we are brutally honest, consumers share the same boat. Instability is not only acceptable in certain producer states, it has arguable utility in terms of underpinning prices to allow for crucial upstream investment: Investment that will inevitably condition future price expectations to boot.

But the key words here are 'certain producers'; what nobody wants is instability spreading to Saudi Arabia or Russia – the two behemoths of the oil world. If Riyadh showed serious signs of political discomfort, we can forget about our price floor dilemma: it would be impossible to put a price on oil at the top. Control would be totally lost. The IEA (and everyone else) would panic. The US would have to decide what course of drastic action was best to take.

The same scenario applies to 10mb/d of Russian supplies outside the cartel. Moscow has long perfected the art of hydrocarbon smoke and mirrors to keep the state (and oligarchs intact), but it remains long on corruption and very short on credible economic modernisation. You'll know if things are bad in Russia if the Kremlin reopens bilateral dialogue with OPEC – a ghost of 2008/9 past.   

And this strikes at our dispensable cogs vs. 'system winners' of course. Who can stand above the fray, and who becomes a function of the instability price floor?  The list isn't easy to draw up, and has got considerably harder in light of Libya.

The US and Europe were clearly looking at total barrels rather than grades involved when it failed to take assertive action in Tripoli; we got a bigger price shock than anyone had anticipated. Letting Libya go should have been relatively easy, alas, it now raises seriously fungability questions as to the real significance of places like Algeria, Nigeria and Angola. If they are still deemed mere 'cogs', they are at least pretty important ones as crucial producers of sweet grades.

Our flip side is that political casualties in Venezuela, Ecuador, Iran, Iraq and some of the smaller Gulf producers such as Qatar and Oman arguably sit on the 'dispensable' list, alongside Kazakhstan in Central Asia and some of the smaller Central and East African producers. Heavier crude losses could be tolerated to some extent to help set the floor, without markets going off the scale.  

But the problem with this goldilocks approach to instability (i.e. just enough to keep prices firm, but not too much to send them into orbit) is that it remains a very dangerous game to play. The idea that anyone can control market price, or gradations of instability, is a leap of faith even the most oligopolistic of thinkers would be unwilling to make.

What might appear initial temporal price corrections can actually become remarkably structural political features of the energy landscape once producer states fall prey to depressed prices. This explains why collective OPEC swing across the Middle East is dead, and why we've all been left holding the Saudi baby.

Likewise, Russia is the only serious player beyond non-OPEC ranks. The Arab Spring will do nothing to dilute Saudi-Russian market concentration, but merely increase its potency as smaller producers drop offline.      

Strategic (non-)thinking: the Saudi-Russia bet

The upshot is that while a 'political risk mechanism' may well be in play, it isn't really serving anybody's interests – on either side of the consumer-producer ledger. Yes, it will continue to firm prices when certain producers struggle to politically adapt to rapidly shifting economic conditions – but if prices even drop below $90/b, a price band that future political outages in peripheral producers is unlikely to support – then upstream investment will probably dry up as rapidly as market confidence evaporates.

Some producers will gain from others misfortune as prices correct, but assuming that more and more producer states hit political problems as prices slip, we are merely cementing a 'too big to fail status' for the oil giants of today, Saudi Arabia and Russia. Untouchables yes, but untouchables that share serious political flaws.

And that's the problem – although we've grasped that prices fluctuate, we remain totally incapable of thinking about – let alone planning for worlds where $50/b (or less) is entirely possible at the bottom, just as much as $250/b is credible at the top should major producers politically implode.

The 'choice' we face is thus a stark one in an increasingly politically and financially constrained world. Should we do all we can to bulk up energy giants, Saudi Arabia and Russia, in the hope they will be sufficient to see us through, or should we start doing serious work to encourage credible economic and political reform across producer states to ensure that when prices correct, political panic doesn't set in?

The latter option is probably the best way forward, not only because it will help to dissolve market concentration at the top, but enable a more robust fringe to collectively act to set credible price bands at the bottom.

Producer states dropping like political flies when prices correct isn't a proper 'solution' for a floor, particularly as it will rebound with a vengeance when markets tighten. The more producers we lose the more dependent we will become on key suppliers.

That's until the Saudis and Russians eventually run out of oil of course, the point at which the 'political no hopers' of today will need to become the major producers of tomorrow. That's a whole new political risk cycle for a whole new day; it's also one we'll come to regret as well."