Oil: Setting the floor

In the space of six months, the oil market has been turned on its head. Prices hit a staggering US$147/b in July 2008, yet today, they are struggling to stay above the US$40/b mark.

Geopolitical friction was undoubtedly used to drive prices up, just as readily as investors ignored political risk when dragging prices back down, but geopolitics now matters more than ever for the oil markets. This is not in the sense of how far it will drive the price up, but more realistically, at what price a floor will be set as the global downturn sets in.

The difficulty for OPEC is that political schisms across the cartel will make notional production cuts difficult to turn into physical reality without Saudi Arabia bearing the brunt of the cuts. But in the longer term, little doubt should remain: Slacking oil prices are more likely to exacerbate resource nationalism and slashed quotas as a means of political survival in producer states, rather than sustained investment and political reform over time.

Bulls to bears: Geopolitics in, geopolitics out

During a stampeding bull market up to July, investors were convinced that tight supply-demand fundamentals could be exploited as they built up a large net-long-term position in crude oil futures from 2004 onward. Every scrap of geopolitical friction was seized upon to push prices higher - ranging from intractable conflicts in Nigeria and Iraq, to shorter term flashpoints of hijacked ships in the Gulf of Aden to the death of Pakistan's Benazir Bhutto, all of which supposedly drew supply-demand fundamentals closer together.

Even failed US presidential candidate Hillary Clinton managed to move the market by firing a "virtual warning shot" across Iranian bows on her campaign trail. It wasn't too long before investment banks started to hint toward forecasts of US$200/b, with Gazprom raising the stakes a little higher to US$250/b.

But that was before the financial crisis and global downturn fully hit. All of a sudden, banks were scrambling to ensure they did not become the next "nightmare on Wall Street" by cashing in positions to boost liquidity and realize capital gains.

In the process, geopolitical risks ranging from Iranian threats to block the Strait of Hormuz, Russo-Georgian hostilities, "open war" declared by insurgents in the oil-rich Niger Delta, and even the hijacking of a Saudi Aramco super tanker in the Gulf of Aden, all failed to quell market decline. Such events merely six months ago would have made prices above US$180/b mark entirely conceivable. Instead, prices now sit perilously close to the US$40/b mark.
  
The return of political risk

Yet if we focus on "market fundamentals" for a moment, it would be churlish to suggest that demand is not softening; it is, and at an alarming rate.

The US Department of Energy has forecast that global oil demand will drop this year by 50,000 barrels, and next year by 450,000 barrels, marking the first two consecutive years' decline in three decades. The same institutions that forecast US$200/b a few months ago have now accordingly revised forecasts down to US$40-50/b, but what such revisions chronically overlook are the political dynamics in play across producer states that will simply not let prices drop to the marginal level of production.

High oil prices have been the political oxygen keeping a number of "unhealthy" governments on life support mechanisms over the past five years. This is a ventilation system that they want to keep running as long as possible. 

Addicted to oil: Not just consumers 

While OPEC gleefully put US$645 billion into state coffers in the first half of 2008, the problem is that most producer states felt this was a price that would never correct, at least not to the degree and pace that it has.

High oil prices were supposed to be the route to political stability and economic growth at home, while projecting power abroad. Instead, it has left Iran, Venezuela and Russia (dubbed the "axis of diesel") precariously exposed to tumbling commodity prices. Libya, Nigeria, Iraq, Algeria and Bolivia, alongside a number of GCC states, are also looking nervously over their shoulders.

In the Persian Gulf, Tehran calibrated its spending to a US$95/b benchmark price - a factor that was useful when "buying" political influence in Iraq, Lebanon (Hizbollah) and Palestine (Hamas), but also for propping up Iranian President Mahmoud Ahmadinejad's domestic support base given that 80 percent of Iran's revenues come from energy. The problem for Ahmadinejad is this that inflation rates now run at 30 percent with very little money left in the Central Bank as international sanctions bite a little harder following gross economic mismanagement of high oil receipts. 

Not to be outdone, Hugo Chavez also balanced his Venezuelan budget on US$95/b. This has already seen the sell-off of government bonds helping to sustain the "Bolivarian Revolution," but how long this can last is debatable. Inflation stands at 36 percent and foreign debt is up from US$30 billion to US$44 billion. Chavez has launched a new campaign to reform the constitution and lift limits on the presidency terms from 2012 onward as a knee-jerk reaction to softening oil prices, but one thing is for sure, he will have to spend less abroad in terms of supporting Fidel Castro, Evo Morales, Daniel Ortega and the opposition FMLN in El Salvador, or risk losing further popularity at home.

Yet it is arguably Russia that is feeling the effects of the oil price collapse most forcibly as the world's second largest oil producer. The Kremlin has already had to draw on oil stabilization funds to prop up the banking sector and rouble, underlining the degree to which Russia is dependent upon and exposed to hydrocarbon price swings. Despite the Kremlins positive "spin" on production cuts, the reality is that Russia can no longer perform its historical role of capitalizing on OPEC cuts to increase its market share due to a long term lack of upstream investment. This helps to explain why Deputy Prime Minister Igor Sechin has been dispatched to OPEC meetings to try and stem the tumbling oil price, as well orchestrating bilateral accords with other producer states struggling to maintain, let alone increase output.

But even with Medvedev pondering how to pay off competing oligarchs in Moscow, any prospective Russian membership in OPEC is simply not in the cards. The Kremlin would never play second fiddle to Saudi Arabia as the main power behind OPEC's throne. If further evidence of Riyadh's domination of the cartel was needed, then consider the fact that despite the Saudi's dropping production to more than 1 million b/d below its peak, the cartel as a whole only complied with half of the agreed production cuts announced since September 2008.

In effect, most producer states have taken the decision that it remains preferable (even at current prices) to keep oil flowing above quota, rather than face the graver shorter term political risk of seeing the taps shut down. Thus, if a floor is to be set, it is ultimately Saudi Arabia that will do it.

Self preservation

This explains why OPEC, and more importantly, Saudi Arabia, failed to cut output when it met in November 2008. This was not about safeguarding long term "demand security," but trying to maintain market credibility as previous cuts failed to be translated into physical reality.

Thus, Saudi Arabia is well aware that if wants to make its latest aim of a US$75/b benchmark price stick, it will personally need to bear the brunt of slashed quotas in order to do so. This is not only because developed countries now have healthy inventories to play with, but more critically because other OPEC and non-OPEC players will "free ride" on the back of Saudi measures.

That said, if Riyadh decides it wants to play to producers rather than consumers wishes, the picture would be radically different. The kingdom can still balance its budget at a modest US$50/b; failure to rein in supply would clearly put al-Saud on a direct collision course with price hawks inside and outside the cartel, but at the same time, it would afford the kingdom considerable political plaudits in Washington, Brussels and Beijing as key energy consumers.

Riyadh is also well aware that its swing producer status remains a useful means of cooling Iranian political ardor on nuclear and geopolitical frictions in order to slowly wrestle back political power from the Persian Gulf to the Levant at a time of its political choosing.

But ultimately, rather like other GCC players, the kingdom has always opted for a strong security apparatus on the back of oil receipts to deal with the symptoms of Shia unrest, rather than address the causes. A failure to cut production sharply now would see prices fall below the US$40/b mark; this is a game that even the al-Saud cannot afford to play from a political or economic perspective.

The upshot is that short-term resource nationalism will become more pronounced in order to cement regimes and economic and political stability rather than allowing prices to fall, or engage in genuine political reform.

This is not to say that the price floor will be set particularly high or will not be extremely creaky given OPEC divisions, but it will be a politically driven floor nonetheless. The grave danger is that no one knows where the "ceiling" might be once the world economy rebounds in the next couple years.

Should leaders across producer states manage to weather current economic and political storms on the back of slashed production and stymied investment, US$147/b might not be too far from the mark.