Fluctuation of the Oil Market - Example

How have the fluctuation of the oil market affected the domestic political economy of the Middle East states? 1. Introduction “The importance of oil is primarily driven by economics” (Jreisat 1997, p.182). The vast oil reserve of the Middle East have brought the region considerable wealth and standard of living much higher than they otherwise would have encounter since domestic production of other tradable goods and services is rather insignificant. However, high oil prices dissuade consumption and encourage the materialization of significant competition, upsetting Middle East oil revenues. Lower prices on the other hand lessen Middle East revenues, then encourage consumption and daunt competition. Many believes that oil price instability persist because of cyclical swings in the market, Middle East politics and OPEC’s frequent deficient reaction to market trends. Because of the uncertainties surrounding the oil industry in the Middle East, unexpected and unpleasant political and economic consequences are unavoidable. The objective of this paper is to uncover how these fluctuations in the oil market affect the political economy of the Middle East. It will cover the major elements of the geopolitics of oil, the cause and effects of prices instability, politics and fluctuating market share, rentier states, oil-revenue-based political system, and the impact of slow growth. 2. Geopolitics of Oil Today, when leaders of developed countries talk about energy policy and security, or future energy source, they are referring to the geopolitics of energy rather than fuel efficiency, solar power, or any of significant alternatives to oil. They are mainly insinuating the actions, money, and coalition essential to keep oil flowing smoothly and reasonably through the subsequent fiscal year (Roberts 2005, p.94). Three significant elements comprised the ever shifting, infinite, and complex geopolitics of oil. The first element is the predominant role of the United States as the world’s fastest growing and largest consumer of oil. As the biggest oil market, the U.S. huge and limitless appetite for oil products wields a persistent pull to the world’s oil producers and political order. According to Roberts (2005, p.95), “one out of every four barrels of oil produced in the world is burned in America” and in 1990s alone, their oil imports grew by 3-5 million barrels a day. With the exception of China and Japan, their oil consumption is in excess of the combined oil utilization of the rest of the world. Thus, no other market can offer major oil exporters, whether country or company, the potential for growth and volume of sales. Moreover, the extent of oil producer’s share in the U.S. market determines his political eminence and future survival. Thus, decisions in the world’s oil industry always take into account the value of the U.S. market. For instance, to protect and retain its share in the U.S. market, Saudi Arabia offers discounted oil prices to the Americans. The U.S. is indeed the focus of world’s oil players since its vast oil market controlled their current and future potential (Roberts 2005, p.95). It is not surprising if the Middle East becomes the second factor in the geopolitics of oil as its vast oil reserve beneath the red sands of Saudi Arabia is “more than a quarter of the world’s known reserves” (Roberts 2005, p. 96). Saudi Arabia has around 265 billion barrels of oil that can be easily refined into almost any oil product and can be process by any oil refineries in the world. The ‘Arab light’, a thin and blush crude is exceptionally cheap to produce unlike oils found in the Gulf of Mexico or Siberia that cost around $15/barrel or even higher. A barrel of Saudi oil is much inexpensive to produce as it only around $1.50/barrel, the most economical in the world (Roberts 2005, p. 96). The United States acknowledges the strategic importance of inexpensive Arab oil to its economic growth and prosperity (Jreisat 1997, p.182). Consequently, this low-cost oil has made the Kingdom very rich and its “domestic deployment of oil revenues profoundly changed the social and economic landscape of Saudi Arabia” (Chaudhry 1997, p.219). The Saudi’s low-cost and almost unlimited oil reserve enables them to grow progressively into the world’s important producer and exporter. They can produce 7.7 to 10 million barrels of oil a day or seven times of the world’s oil demand. Because of cheap and highly compliant oil quality, the Saudis becomes more adaptable and can maintain a large half a million barrels per day standby production capacity that includes great networks of wells, pipelines, and loading facilities that they can easily use when the demand escalates (Roberts 2005, p. 96). The third and the ultimate factor in the geopolitics of oil is price. “When oil prices increase, they will have negative impacts on the international economy. When the international economy shrinks, the oil demand will decline and vice versa, i.e. when the international economy grows, the demand for oil also grows.” (Al Muhanna 2004, p.1). Relatively, if our first factor controls the future of oil exporters through its vast market and the Middle East enforced the oil market, the price of oil is the impulse. The price of oil drives the entire geopolitical mechanism in motion. It controls the course and rate of flow of international money and political power. The rate of growth of a country’s economy depends on price thus; oil industry players are endlessly trying to control it. For instance, economies that depend on cheap oil like the United States and Europe will do anything to keep it low. These governments can put pressure on OPEC when prices get too high, while oil companies may create artificial shortage of supply to stir prices and earn big money out of it. ‘Squeezing the market’ is a tactic associated with oil companies buying large quantities of a particular grade of oil like ‘Arab Extra Light’ to temporary drive up prices for that grade by around $5/barrel. Companies then sell these ‘squeezed oil’ to obtain extensively large profits (Roberts 2005, p. 97). Similarly, experience tells us that some oil states have attempted to use oil prices as a tool to drive prices up. Some oil states flood the market with oil to bring prices down or withhold their supplies to bring oil prices up. Unfortunately, these strategies often rebound as destabilizing prices can result to caustic sequence of events that has, on numerous juncture, results to near economic destruction and war. This is the reason why price stability becomes the dominant objective of countries as politically divergent as Saudi Arabia, Russia, and the United States (Roberts 2005, p. 97) 3. The Cause and Effects of Price Instability “After price, everything else is secondary” (Roberts 2005, p.98). According to Okogu (2003, p.2), the world oil market for the past three decades has experienced remarkable transformation, starting from the renegotiation of the ‘posted price’ (Okugo 2003, p.1). It is a concept sponsored by major oil concession companies to convince oil states that there was one price for all. Mobil made the first posting in October 1950 for Iraqi Kirkuk crude followed by posting of Arabian Light crude a month later. The companies were then able to say to the governments that they should sell their oil according to the current posted price, as no one will pay more than that (Parra 2004, p.62). The ‘posted price’ is a reference price on which royalties to host countries were calculated until early 1970s. Earlier than that, this price was fixed at $1.80 a barrel during the 1960s by the major oil concession companies in these oil states. The following events concluded in the 1973 oil price shock and the eventual transfer of property rights to the host countries presage the beginning of a new epoch in the oil industry (Okugo 2003, p.1). According to Owen and Pamuk (1998, p. 100), the ‘quadrupling’ of the world price of oil starting in this period initiated the high-speed movement of wealth in the 20th century because the inward stream of unparalleled amounts of foreign exchange in the Middle East pushed the region to a major economic growth. In UAE for instance, based on the report of Global Investment House (2007, p.1), their oil and gas sector contributed 3.5 percent of the economy in 2005 due to the rising oil prices floating around $50.6 per barrel. Middle Eastern countries as members of the Organization of the Petroleum Exporting Countries (OPEC) were at the core of the revolution of the market because have since they possess the largest oil reserves in the world. Moreover, aside from the social transformation brought by sizeable oil revenues, these oil states were faced by new challenges specifically in matters concerning economic policy and administration. This includes learning to survive the undesirable effect of oil price volatility (Okugo 2003, p.2). In the late 1970s, the high oil price level following the 1973 oil shock, high-cost oil regions like the North Sea, Canada, and Mexico were explored for oil. However, output was minimal as Western Europe can only produced half a million barrels/day. The North Sea field only became beneficial in 1975 in the midst of OPEC induced higher oil prices coupled with encouraging upstream tax incentives for oil companies. In the advent of new technology, North Sea production capacity reached 3.8 million barrels/day in 1985 and in 2002, the field’s output doubled to 6.7 million barrels/day. New technologies enable new high-cost fields to be advantageously developed and reduced production cost overall. Consequently, OPEC’s market share considerably deteriorates as rising non-OPEC output more than absorbed the incremental demand. In order to defend the price, OPEC in a fruitless effort, was forced to carry out successive rounds of ‘quota cuts’ (Okugo 2003, p.3). Certainly, OPEC was once successful in setting the pace in the industry. An analysis of the condition that enable OPEC to effectively direct the oil price in the 1970s and early 1980s exposed the changes the oil market has experienced and the reasons why oil states particularly those in the Middle East could no longer ignore any level of income coming from the oil sector. According to Okugo (2003, p.4), the inability of the oil the state to depend entirely on oil revenues underscore the need to speed up economic restructuring and diversification. To understand the main features of the oil market during those years, one must be aware that just after it plunged in 1974 and 1975, the global demand grew by almost 10 percent between 1976 and 1979. This considerable growth rate facilitated a much better opportunity for OPEC to control its member’s activities and production quantities. Consequently, though partly doing well, OPEC’s quota policy forced the oil market to stabilise. However, the loss of output from Iran caused by the Iranian revolution, coupled by speculations on the part of market agents pushed oil prices up in 1979 to 1980. The effect of the price increase together with deteriorating world economic growth made oil demands to fall by 4.5 percent in 1980 and another 3 percent in the following year (Okugo 2003, p.4). Essentially, we need to note that the present level of supplies from non-OPEC is much higher than in 1970s and the cost of production particularly in the North Sea of about $15/barrel, restrict the growth of these non-OPEC sources. Thus, their share of the incremental demand was not big enough to destabilize the market or to alarm OPEC. However, the present situation is a lot different, as decline in the production cost brought about by new exploration technologies strengthens the non-OPEC’s grip on the market (Okugo 2003, p.4). In the early years, although there was substantiation of declining energy intensity, technical innovations in the industrial, commercial, transportation, and household sectors were not given much importance. The broad effect of technology only become apparent in the 1980s when the amount of energy necessary to generate a particular amount of GDP is getting lower, thus growth in energy demand became modest (Okugo 2003, p.5). We should also consider that the international oil trade system during those years was largely based on term contracts, where negotiations on prices and volumes were being made on a quarterly basis. Therefore, the market had a point of reference over a known period and OPEC-driven pricing system worked effectively this way. Although there was no unity on oil prices in the industry’s literature in those years, this may have accidentally justified the OPEC price system that gave major oil exporters a false sense of confidence about the future of oil prices and delayed their essential economic reforms. However, in real and nominal terms, the price of oil dropped since the 1980s (Okugo 2003, p.5). In general, the situation in the oil market during the 1970s was in favour of OPEC’s price-setting system when applied to a certain market condition. Therefore, when market conditions change dramatically due to non-OPEC output increase, OPEC’s market power decreases and oil revenues become unpredictable. 4. Politics and Fluctuating Market Share Since 1973, Noreng (2002, p. 108) explains, the majority of oil states in the Middle East seem secure over their market share. They do not pay much attention on the effects of low oil prices on rising market share nor deteriorating market share caused by comparatively low oil prices. They do not realize that the increase in their income brought by increased output and lowered oil prices is only temporary and they may lose market share. Most oil states in the Middle East at times manage to make OPEC operate as a cartel where they manipulate quotas and market shares. However, disregarding OPEC agreements, they themselves compete for market shares at other times. Oil states standby capacity enables them to stabilize the oil market by adjusting their supplies to demand instability. However, in several occasion, their technique has also contributed to the sudden deterioration of oil prices. The Middle East is the outstanding supplier of oil thus the price maker but with low market share way below the reserves. Hence, there is an inclination for the comparatively limited high-cost oil in other parts of the world to be depleted before the more bountiful and inexpensive oil in the Middle East (Noreng 2006, p.108). The overall supply of oil in the market at any given time is at random. Noreng (2006, p.109) argues that it is not determined by economic factors but Middle East politics and government interest. This is because he believes that there is no connection between oil prices and volumes obtained in the Middle East and there is no such thing as insignificant cost and stable symmetry in the oil market but mere recurring trends with economic and political factors working together and governments sporadically playing their role. The Middle East oil industry he added are either completely nationalised or in meticulous government control and for this reason, “there is no market for oil in the classical sense” Noreng (2006, p.109). The leading players are the diminutive number of suppliers or ‘oligopolist’ and governments in the background. Although economic conditions and quandaries were reasons for conflicting oil policy objectives, politics plays an important role in the analysis. In the same manner in which oil states work together in stabilizing the market, they are also capable of alienating each other by withdrawing cooperation, disregarding pertinent oil interests of their immediate neighbours. Thus, they are also capable of challenging their neighbour’s essential economic interests and political stability. In sum, they can inflict damage to each other through their oil policies and in some severe cases; conflict on oil policy creates war. The Gulf War, for instance, can be seen as a conflict inspired by oil thus oil policies in these states have at least two components, economic interests and regional concerns. However, in some cases, wider international concerns can be a third component. For this reason, issues of external power interest with the oil states power balance is of great significance in oil prices (Noreng 2006, p.109). Earlier conflicts between these states, for instance, Iraq against Iran or Saudi Arabia and Kuwait pushed the oil price down. The reason behind it is the fact that Saudi Arabia or Kuwait needs external supports particularly from the Americans thus it needs to give the large oil consumer some consideration or some special discounts. In contrast, the settlement of such conflicts can stabilize the oil price at a higher level for the obvious reason that these oil states no longer need to consider the Americans oil interest. Mutual trust between these oil states is therefore an essential pre-condition for OPEC in stabilizing the oil market. Foreign and security policy are components of Saudi Arabia and Kuwait’s oil policy while economic seems to preponderate the oil policies of Iran and Iraq (Noreng 2006, p.109). 5. Economic Rent In view of the fact that no major Middle Eastern oil exporter at this time has been able to industrialize and to subsist on the average return on investment, they all depend on the economic rent accruing from oil. Noreng (2006, p.118) explains that the reliance on ‘economic rent’ means “living off revenues without a corresponding investment” and doing so would result in a short-term political convenience but increased economic risk that was evident in 1998 oil price crisis. Since the government operation of oil states entirely depends on exports of one commodity, they experience serious financial problems when oil prices plummeted in 1998. “The oil collapse was a shared economic disaster with potentially ominous social and political repercussions” (Noreng 2006, p.118). According to Heradstveit and Hveem (2004, p.11), there has been as a minimum a link between mounting oil revenues and delayed political reforms. For instance, oil states have been reported spending extravagantly on community development in the preceding years of reasonably high oil prices. However, when oil prices dropped considerably in late 1997 until early 1999, oil states suffered tremendously. Although the threshold of economic pain varies by states, there was an incontrovertible desire to avoid low prices or stabilize it at a high level. The impact of low prices indeed varies depends on circumstances, for instance, Kuwait or the UAE would not suffer much as their earnings from huge foreign assets cushioned its economic effect. Comparatively rich Saudi Arabia in 1998 experienced negative economic growth of at around 8 percent, with the rapid fall of the current account balance. Fiscal crisis happened as low oil prices caused export revenues to fall by about 40 percent (Noreng 2006, p.118). The fiscal management in an oil economy Askari (2006, p.146) explain, is much greater compared to a non-oil economy as highly fluctuating oil revenues directly affects their economy. Therefore they must learn to save or invest as the impact of higher oil prices on oil exporting countries IEA (2004, p.3) explains, depends on how the extra revenues are spent. 6. Oil Revenue-based Political System In the Middle East, oil has caused a special, capital-intensive mode of development. Oil exporting countries “economic development and political stability depends on the flow of oil” (Alnasrawi 1991, p.75). Heradstveit and Hveem (2004, p.11) explains that with high oil revenues, capital accumulation could take place at a much higher rate in the public sector than in private business. This is because, they added, the accumulation process is controlled public servant and autocratic rulers instead of the private capitalist. For this reason, revenues from oil reinforced the state and its ruler resulting to an oil-revenue based political system. Dissimilar to other countries, significant revenues from oil makes an oil state simply a distributor of economic rent than being a tax collector and distributors. Therefore, oil-states do not give much emphasis on private production, export, and investment. Consequently, private sector in these states does not have any political significance. In summary, the political process in an oil revenue dependent state, government do not tax the population but rather use oil revenues to grant selective privileges in return for allegiance and support from mainly scrounging private sector. The distinctive feature of an oil-state particularly in the Middle East is the channelling of hefty oil revenues through government treasuries. Most economic activities outside the petroleum sector depend on government permits, contracts, support and protection. This is typically coupled with lack of taxes on property and income, excluding religious taxes or ‘zakat’ (Heradstveit and Hveem 2004, p.11). Consequently, the Middle Eastern oil states have no market economy, but rather a protected concessionary and distributive economy, directed by the government (Forest and Sousa 2006, p.131). The distinction with the independent capitalist development of the Western world is remarkable. In the developed capitalist economies, organized economic interests use the state for their political purposes. In the Middle East oil states exporting countries, the state uses private business for its political purposes. This is a basic feature of the ‘rentier’ state (Noreng 2006, p.119) which according to Heradstveit and Hveem (2004, p.11) is a state that needs access to economic rent to survive. A state with no direct taxation does not need to prove its legitimacy to its citizens thus the need for liberal and democratic reforms diminished. “The politically conditioned need for revenues, to buy support and legitimacy, reduces oil policy discretion” (Heradstveit and Hveem 2004, p.11). The need to buy support results to maintaining a critical minimum of revenues thus when oil prices fall and oil revenues plunge below the critical minimum, governments tend to make upsetting decisions. This was the case of Iran and Saudi Arabia in 1998 to 1999. According to Noreng (2006, p.120), these oil states suddenly turn to income and property tax, when oil revenues continue to fall under the critical minimum for a considerable long period. 7. The Impact of Slow Growth Any disproportionate price hikes could distress world economic growth, lead to a drop in demand, and reduce prices through income effect (Kato 2005, p.7). Similar to 2001, development in the Middle East according to the IMF (2002, p.48) report would decelerate considerably in 2002 due to low oil production and regional situation. Moreover, OPEC’s agreement limiting global supply has depressed the activities in these states. Growth rate is expected to slow from 5 percent in 2001 to 3.4 in 2002. However, if sustained, IMF added, increases in oil prices might help support growth. The impact of slow growth in the region has been restricted by sensible macroeconomic policies specifically the ‘boom and bust cycle’ of the past where government spending corresponds to the rise and fall of oil prices. However, Saudi Arabia’s growth is expected to be negative in 2002 because the slowdown in activity in this country has been more distinct. In order to reduce inflation and avoid continues appreciation of the country’s real exchange rate, IMF suggested that they should continue with sensible macroeconomics policies. Undoubtedly, low oil prices hurt oil-states and benefits large consumers. However, the most prominent according to Park (1992, p.8) is the asymmetrical combined losses of oil producers against relatively very small gains of oil consumers in the region. The reason for this he added is the tremendous reliance of the region’s economies on oil revenues, and the non-existent or comparatively insignificant debt burdens of the region’s economies compared to other regions of the world. 8. Conclusion The geopolitics of oil is continually changing, boundless, and multifaceted. It involves actions, money, and alliances to maintain the smooth flow of oil in the world market. Large consumer like the United States plays a major role in geopolitics of oil because it offers chief oil exporters potential for growth and large volume of sales. Similarly, playing an equally significant role is the cheap and almost unlimited oil reserve of the Middle East that can deliver almost seven times of the world’s oil demand. However, these players depend on ‘price’ as it drives the entire geopolitical mechanism in motion and controls the course and rate of flow of international money and political power. The rate of growth of an oil states economy depend on price thus fluctuation in oil prices affects the Middle East. Oil price and market stability are influenced by numerous factors. Pressures from large economies that depend on cheap oil like the U.S. and Europe can prevent oil prices from stabilizing at a higher level. In contrast, oil states can withhold their supplies to bring oil prices up. Furthermore, stiff competition from non-OPEC oil producers can reduce market shares. High oil prices help the Middle East economy grow but it can also reduce their shares in the market as consumers fall back on cheaper alternative. The political and economic impact of oil price and market instability in the Middle East is extremely different and more severe than non-Middle Eastern oil exporters. This is because Middle Eastern oil states depends on exports of one commodity and is completely reliant on oil revenues. They are all living off revenues from oil without a corresponding investment. Moreover, significant revenues for oil make an oil state government merely a distributor of economic rent than being a tax collector and distributor thus private sector in these states has no political weight. Governments do not tax its citizens but use oil revenues to grant selective economic privileges in return for loyalty and support. Consequently, the Middle East oil states have no market economy but a protected concessionary and distributive economy directed by government. Therefore, fluctuations in the oil market instantaneously and severely affect the political economy of the state. 9. 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