Oil: Winners and Losers

The slide in the price of crude oil is unmitigated disaster for most oil producers and cause for joy for oil-importing countries. But there are dramatic layers and layers beneath this rather simplistic observation. Why is OPEC so sanguine in the teeth of what seems a price catastrophe? Who else, apart from oil importers, stands to benefit from lower prices? What are the global political and power ramifications? How are African countries, especially oil producers, dealing with this situation? What are the implications for the new oil nations? Neil Ford analyses a complex conundrum.

International oil prices have collapsed since the middle of 2014, causing dismay for African net oil exporters and celebration among the more numerous importers.

The price of Brent crude has fallen from $116/bbl last June to $47.43/bbl at the time of writing [13 January] with little indication of its future direction. The dramatic fall came without any warning and, as so often, the only predictable thing about the global oil price has been its unpredictability.

Forecasting oil prices is notoriously difficult. Few pundits expected the dramatic fall in prices over the past eight months and no ºone can provide an accurate forecast for the rest of the 2015, although this does not stop analysts and journalists from writing thousands of pages attempting to do just that.

However, as the price continues to fall, few expect the price to rebound dramatically any time soon. It is equally impossible to predict at what level the price will bottom out, with some even suggesting that $20/bbl is possible.

There are several causes of the collapse: higher production, including of shale oil in the US; lower demand growth, particularly in China, the US and Europe; and OPEC’s refusal to rein in production.

Despite lower than anticipated output in Nigeria and Libya, the world’s three biggest producers – the US, Russia and Saudi Arabia – are each producing more than 10m b/d. US shale oil production reached 2.4m b/d last year and another 1m b/d is expected to come on stream by 2017. This phenomenon has already changed the direction of Nigerian oil exports, with India now overtaking the US as the biggest market for Nigerian crude. Elsewhere, Iraqi oil production is recovering and years of the $100/bbl have encouraged the development of projects in frontier areas around the globe.

At the same time, Chinese economic growth is slowing and the European Union has not recovered as quickly as expected, depressing demand for energy. Even where there has been stronger economic growth over the past 12 months, such as in the US and UK, energy consumption has not grown at a similar rate. Energy efficiency is having an impact, while growth has been strongest in the service sector rather than in manufacturing or heavy industry.

The market is supposed – to some extent – to be self-regulating. High oil prices should trigger most investment in upstream exploration and the development of fields that have already been discovered but on which production is more expensive. Low prices should rein in exploration and production on high-cost fields.

In addition, OPEC has acted as a safety value for the industry, increasing or reducing the quotas imposed on its members in order to keep oil prices within a specified range. Although the proportion of global output controlled by OPEC has steadily fallen over many years, the cartel has continued to fulfil this function until recently.

OPEC’s complex motives
At the last OPEC meeting in November, the cartel somewhat surprisingly decided to maintain quota levels. Secretary general Abdalla El-Badri said that it would “produce 30m b/d for the next six months, and we will watch to see how the market behaves”.

The oil producers’ organisation is meant to be a club of equals but some members are clearly more equal than others. Although some negotiators were keen to see quotas reduced in order to inflate prices, Saudi Arabia’s demand for inaction won the day.

The Saudi Arabian Minister of Oil, Ali al-Naimi, said that production will not be reduced even if oil falls to $20/bbl. In December, he reiterated that production would not be curtailed but added that there was no reason why prices should fall so dramatically. This conclusion is regularly trotted out when oil prices soar or collapse, and basically underlines the fact that prices are highly unpredictable.

There are several possible explanations for this approach. Firstly, OPEC members are keen to maintain their own oil production in order to fund planned spending, part of which is motivated by a desire to control social tensions and maintain the recovery from the global financial crisis.

However, revenues are likely to suffer more from low prices than from a more modest cut in output. Moreover, the Gulf oil producers were most keen to maintain production but they have the healthiest finances and so this is unlikely to be the main cause.

Secondly, OPEC may wish to counter the threat from North American unconventional oil producers to market share and to long-term high oil prices. On previous occasions, Saudi Arabia has lost market share when it has cut production, but Gulf states have much lower oil production costs than US shale oil producers.

Some shale oil fields could be mothballed for a time if low prices persist, other projects could be postponed and some shale oil companies could become bankrupt. The industry is dominated by smaller niche firms rather than the US oil majors with deeper pockets.

Yet any recovery in international oil prices would merely see shale oil production rebound, albeit with a slightly different group of investors. The North American oil industry is flexible enough for capital to flow in and out of the industry as required.

There is a third theory that has been proposed by several commentators: that the Gulf states are deliberating allowing oil prices to drift lower in order to put pressure on Tehran over its nuclear ambitions and intervention in Syria.

Saudi and UAE ministers may describe Islamic State as a bigger threat to the region than Iran but weakening Iran would hardly have a negative effect on the battle against IS. If Iran were to cease military support for Syria’s President Bashar al-Assad, then it could be easier for the West and the Gulf states to fight IS in Syria, without fear of inadvertently shoring up their common enemy. Tehran’s fragile finances have already been hit by the lower oil price, with government monthly revenues down $1bn by December.

For better or worse, OPEC’s failure to act certainly makes it complicit in the low oil price, although the organisation does not accept that any of these theories are true. El-Badri said: “Some people say this decision was directed at the US and shale oil. All of this is incorrect. Some also say it was directed at Iran and Russia. This also is incorrect.”

A variable impact
The impact of low prices on the oil industry varies according to the geology, location and investment regime in question. The cost of producing oil is generally lower on onshore fields without significant technological challenges but rises on onshore fields, particularly those in deep-water areas and on unconventional oil projects, such as shale oil fields in the US.

Onshore Gulf production costs, for instance, average about $10 a barrel, in comparison with about $60 a barrel for US shale oil. Gulf of Guinea deep-water production costs are close to the latter, while the poor security situation in the Niger Delta makes Nigerian onshore and shallow-water production relatively expensive.

However, there is also a political angle to oil prices. Washington relies on oil revenues for only a small proportion of its income but OPEC member states base their entire finances on hydrocarbon income.

It is interesting to consider the level of oil prices required to balance the budget of OPEC member states. According to figures from the IMF and Deutsche Bank, Saudi Arabia needs $104/bbl and the United Arab Emirates (UAE) just $81/bbl in order to balance their budgets. All the African OPEC members are in a worse state with Nigeria at $123/bbl, Algeria $131/bbl and Libya an incredible $184/bbl, while the Angolan government puts its own breakeven figure at $98/bbl.

At conference after conference over the past three months, oil ministers and oil company executives have lined up to state that they will base their investment decisions on long-term developments in the oil industry and not on short-term market fluctuations.

The survival of state-owned OPEC oil companies is not at risk, but their private sector Western counterparts could come under real threat. Some US shale oil producers have already begun to cancel rig contracts.

It has rightly been pointed out that even Saudi Arabia, Kuwait and the UAE will have to cut social spending if oil prices were to stay low over an extended period, but this would bite almost all other net oil exporters much earlier, including those in Africa.

Iain Armstrong, oil market analyst at investment management firm Brewin Dolphin, says: “All the net exporters of oil are the ones that are suffering at the moment. Unless you’re lucky enough to be tied to the dollar, your currency is going to be in big trouble, i.e. just like Russia.”

Most governments have welcomed the lower oil price: it helps to reduce inflation and make consumers better off. Lower prices encourage consumption and although this is likely to drive up carbon emissions, it also gives governments much greater scope to increase or introduce environmental energy taxes. In addition, airlines should reduce the surcharges that they have imposed in recent years because of high fuel prices, encouraging air travel.

These benefits will be shared by most African nations. While the continent’s net oil exporters will surely suffer, the net importers will benefit and there are still more than twice as many net importers as exporters in Africa.

Apart from lower fuel costs, they should gain from lower transport costs for all other products. Consumers will have more money to spend on other products, helping to stimulate other parts of their economies.

A time for subsidy cuts
The various African governments that subsidise fuel price could also take the opportunity to cut this expense, as there would be less political fallout now than at a time of high oil prices. This is therefore an excellent occasion on which to improve government finances.

Such subsidies generally benefit the African middle classes more than poorer people. According to the IMF, a total of $480bn was spent on fuel subsidies around the world in 2011, comprising an average of 2% of global government spending. However, this figure masks huge variations around the world, with most countries providing no subsidies on petrol or diesel consumption. Forty countries still subsidise fuel prices, mostly net oil exporters or African countries.

The World Bank has already called on the governments of developing countries to reduce or remove fuel subsidies in order to improve public finances. In a statement, it argued: “Continued soft commodity prices … would offer an opportunity to implement subsidy reform, which would both help rebuild fiscal space and lessen distortions associated with these subsidies … Fiscal space has shrunk since the Great Recession and has not returned to pre-crisis levels. Thus, developing economies need to rebuild buffers at a pace appropriate to country specific conditions.”

Some governments are already adopting this policy. The Indonesian government plans to switch expenditure from fuel subsidies to education and infrastructural projects, while India has phased out diesel subsidies.

Ayhan Kose, the director of development prospects at the World Bank, says: “These are countries that have taken substantial measures, but this is a great time to do more, for oil importers as well as oil exporters. The rebuilding of fiscal buffers will provide the room required to support activity during times of economic stress. The need for additional fiscal buffers is more pronounced now in an environment of uncertain growth prospects, limited policy options, and likely tighter global financial conditions.”

Even if governments fail to end subsidies, it is vital that they do not reduce fuel prices in line with the fall in crude prices. Subsidies are a controversial policy in any case because they divert money from other areas, but they are designed to rein in fuel costs when crude prices are high, rather than providing a constant discount.

In recent years, Algeria and Libya have spent more than 10% of their GDP on fuel subsidies, while they accounted for a massive 11% of Egyptian GDP in 2013, seven times more than the national health budget and equivalent to the national budget deficit.

The new government of Egypt has already pledged to phase out all fuel, gas and power subsidies by 2019 in order to reduce its budget deficit and this timetable could be speeded up if prices remain low. Under its existing plan, Cairo expected to spend $13bn on subsidies this year but this figure has already fallen to $10bn as a result of the low price of oil.

Angola has also acted. Luanda increased motor fuel prices by 20% in December: with petrol rising from 75 kwanza/litre to 90 kwanza/litre ($0.88/litre) and diesel from 60 kwanza/litre to 50 kwanza/litre. This will have a massive effect given that crude oil prices are heading in the opposite direction.

 President José Eduardo dos Santos said that 2015 “will be economically difficult because of significantly low oil prices. Some public expenditures will be reduced and some projects postponed. Tougher state budget controls and financial discipline will have to be enforced to keep stability. However, we will maintain our poverty-reduction policy. There are Angolans who live with very little or almost nothing.” The government had already forecast a budget deficit of 2% this year and deficits every subsequent year until 2019.

Budget cuts
Both Algeria and Angola will have to borrow or severely cut expenditure but at least their sovereign debt levels are comparatively low. Other African oil producers will probably have to increase their borrowing while also paying more for the privilege because of their weaker financial positions.

Nigeria could be particularly hard hit. The value of the naira had fallen to N180 to the US dollar by the time of writing [13 January], close to its historic low. Even in mid-December, the Nigerian government was forced to redraft its budget based on an average oil price this year of $65/bbl. Federal government capital expenditure has been cut by 59% and some taxes increased. Abuja had assumed an average oil price for 2015 of $77.5 b/d, although this would still have left the government needing to borrow.

Lower oil revenues should encourage the government to push ahead with plans for economic diversification. Finance Minister Ngozi Okonjo-Iweala said that Nigerians should begin to think of their country as a non-oil economy.

She added: “This budget is based on a few key indicators, $65 a barrel benchmark and we are going to stick to it for now, in spite of the decline in prices, because we feel the average price next year will be around $65 to $70.

The production level is 2.27m b/d. We’ve revised the growth rate based on the new parameters for the country, down from 6.35% to 5.5% next year. But that is still one of the fastest growth rates we’re experiencing in the world today.”

While Saudi Arabia has a massive $900bn in cash reserves, Nigeria does not have the level of reserves required to ride out a long period of low oil prices. Moreover, successive Nigerian governments have struggled to reduce fuel subsidies but many people seem determined to make sure that motorists benefit from falling crude prices. Workers in the Nigerian oil industry went so far as to hold a four-day strike in December in support of lower petrol and diesel prices.

Elsewhere, the low oil price will affect the development of planned projects that have not yet come on stream, such as in Ghana, which have been predicated on much higher revenues.

Lower oil prices may also exacerbate existing political, economic and security problems in South Sudan. Some sources suggest that the country received just $20-25/bbl at the end of 2014, possibly the lowest rate in the world, because of the terms of its transit pipeline deal with Khartoum. Further west, the low oil price has come at a particularly bad time for Gulf of Guinea oil producers because – in addition to their high deep-water production costs – shipping rates between West Africa and China have increased sharply over the past six months. They are already at a disadvantage to their Middle Eastern competitors in supplying oil to Asian customers in that Middle Eastern producers have the added benefit of shorter shipping routes to Asia.

The implications for East Africa are more complicated. As an oil importing region, it should benefit in the short term but projects in Uganda and Kenya are unlikely to be commercially viable at current price levels.

However, although the price of piped gas is often tied to crude oil prices, it should not affect plans to develop liquefied natural gas (LNG) projects in Tanzania and Mozambique. The wide oil price fluctuations over the past decade should remind all countries in the region that oil is not an alternative to wider based economic growth, particularly in countries with relatively large populations.

The low prices may remind governments across the region – if they need reminding – that the Nigerian model of the past 40 years is not one to follow.

Lower oil prices are generally regarded as positive for global economic growth but there is an economic risk to some of Africa’s biggest trading partners. While inflation is broadly speaking regarded as a threat to economic development, a modicum of inflation is required to encourage investment and saving, as well as to erode the scale of debt.

As Japan has experienced over the past 15 years, consumers spend less if prices are likely to fall over time. Hardly any other countries have had to face deflation in modern times but prices did fall in the Eurozone in the last quarter of 2014 for the first time ever, partly because of falling oil prices.

Sustained deflation in Europe could exacerbate existing debt and deficit problems, curtailing demand for African exports. In addition, low oil prices could destabilise a raft of oil producers around the world, such as Russia, Venezuela and Iran, creating new security problems with the potential to upset global growth. On balance, however, the grins on the faces of most African finance ministers will become ever wider as oil prices continue to fall.