From Stratfor

Heading into 2019, oil producers are getting the feeling that they’ve seen this market before. That suspicion was reinforced last month when the price of global benchmark Brent crude briefly fell below $50 for the first time since June 2017. In addition, for the second time in five years, declining oil prices have forced global oil producers to stabilize the market by cutting production by 1.2 million barrels per day (bpd). And for the second time in those five years, producers will have to deal with the consequences of low prices, even if the pain might not be as bad this time around.

An Oil Market Under Pressure

Russia, Saudi Arabia and other members of OPEC may have been victims of their own success in 2018. After cutting oil production to start 2017, resulting in the slow rise in prices during 2017 and 2018, the coalition of OPEC and non-OPEC countries — the so-called OPEC+ — decided in June 2017 to relax some production curbs. But higher oil prices also spurred tight oil producers in North America — the nemesis of OPEC+ — to boost investment to accelerate production growth. As a result, U.S. production hit a record 11.5 million bpd in October 2018 — a nearly 2 million bpd increase over the previous year.

High growth in U.S. production, rising output from Saudi Arabia, sanctions waivers for the purchase of Iranian oil and a weak global economy due to the U.S. trade war, prompted oil markets to begin a sell-off. While prices are likely to rise in part because of Riyadh’s decision to cut production again (U.S. President Donald Trump had pressured Saudi Arabia to increase production before the Iran sanctions took effect in November 2018), there is no escaping the simple truth: The oil market remains oversupplied, even with the cuts. What’s more, U.S. output will likely provide all the growth — if not more — that is needed to satisfy the market in 2019. As a result, prices could remain at current lows for much of the year, with most estimates ranging from $40 to $75 per barrel.

The recent drop in prices resembles the fall seen in the second half of 2014. This time around, however, many oil producers won’t have to make the same painstaking economic adjustments as they did in 2015. Most have already implemented long-term initiatives to alleviate the problems created by low prices. So what, precisely, is in store for some of the world’s most important producers?

Saudi Arabia Unfazed

Crown Prince Mohammed bin Salman responded to falling oil prices by promising to reduce subsidies and institute significant austerity measures in 2015, when the country’s budget deficit peaked at $97.9 billion. Riyadh also launched the Vision 2030 plan in April 2016 to increase the kingdom’s revenue from non-oil streams, to boost the private sector and to diversify the economy away from a dependence on oil exports. Although Riyadh has seen success with some Vision 2030 goals (non-oil revenue rose from 115 billion riyals in 2014 to 287 billion riyals ($76.5 billion) in 2018), it has struggled to entice foreign investment and to jump-start the private sector. Both goals lie at the heart of Vision 2030.

To pick up the slack, Riyadh has had to fall back on its long-standing economic strategy: make the necessary investments on its own or resort to its sovereign wealth fund, the Public Investment Fund, to pay for domestic projects. Lower oil prices put the desert kingdom in a bind. It cannot make the necessary adjustments to quickly stimulate the private sector or attract investment, even though it must shore up its domestic economy since the crown prince remains under global pressure after the murder of dissident journalist Jamal Khashoggi. Saudi Arabia’s budget for 2019 aims to do the latter. Riyadh is planning not only to introduce its highest budget ever but also to boost capital spending by 20 percent, meaning it needs an oil price of about $90 per barrel to break even. But because the kingdom wishes to maintain its spending plans despite low oil prices, Riyadh will likely continue to rack up debt at a significant pace.

Russia’s Many Headaches

Like Saudi Arabia, Russia suffered some significant pain in 2014 and 2015 as prices declined. Moreover, Moscow opted to continue floating the ruble on international currency markets, causing it to substantially weaken as oil prices fell. For Russia, this decision has had contrasting ramifications. While it did make imports more expensive and force the Kremlin to rely more on borrowing and reserve withdrawals to plug budget holes, it also boosted non-oil exports, since the weakened ruble made Russian agriculture and industrial goods more competitive. Moscow also adopted a wise approach to rising oil prices by avoiding the temptation to implement an expansionary budget; instead, it took any oil revenue above $40 per barrel and deposited it in a rainy-day fund or used it to reduce its deficit. It has also pursued more comprehensive reform efforts at home, increasing its value added tax from 18 percent to 20 percent for the 2019 budget and continuing austerity measures, which led to a small budget surplus last year.

A lower oil price will certainly result in a budget deficit for Russia, but low prices are just one of many concerns for its economy. Washington continues to expand its sanctions against the Kremlin in a number of fields, even threatening measures against Russian energy pipelines, such as Nord Stream 2, which would jeopardize aspects of Moscow’s long-term economic strategy. For the past five years, Moscow has emphasized reducing its economic dependence on the West by expanding economic ties to Asia, but the move has ultimately provided Russia with little succor due to the downturn in Asian markets amid the U.S.-China trade war.

Iran’s Worst Nightmare

Perhaps no country will feel the pinch from lower prices as much as Iran. The country’s oil exports had already fallen by about 1 million bpd due to the U.S. decision to reintroduce sanctions after pulling out of the Iranian nuclear deal, but the low prices will only exacerbate the situation for the Islamic republic. The Trump administration granted 180-day waivers to eight countries to let them continue importing Iranian oil in part because of the October 2018 spike in oil prices. But if the market remains oversupplied by the time the waivers come up for renewal in May, Washington will have more room to press Tehran’s customers to further reduce — or eliminate — those imports. For Iran, the prospect that it will lose most of its buyers is even more worrying than the decline in the price of oil itself, given that the knock-on economic effects are causing serious political repercussions at home.

On Dec. 25, 2018, President Hassan Rouhani presented the country’s 2019-20 budget, which envisions about 1 million to 1.5 million bpd of oil exports, as well as a price of $50 to $54 per barrel. But even if Iran attains that level of exports, it will suffer an economic recession due to the precipitous drop in oil exports and the increased cost of imports due to the rial’s steep decline, as well as U.S. efforts to limit the country’s access to hard currency. Politically, this will continue to weaken Rouhani to the benefit of Iran’s conservatives and hard-liners, although the Islamic republic will, for the time being, achieve the bare minimum — avoiding an economic collapse.

Iraq Struggles to Dole out Its Oil Wealth

Iraq, now the world’s fourth-largest oil producer, faced two major challenges during the last price dip in 2014. Not only did prices collapse, sending Baghdad into a financial tailspin, but the Islamic State also raced across western and northern Iraq, capturing key areas of production. And while the militant group is no longer capable of holding urban centers like Mosul, it remains a terrorist threat. What’s more, Iraq can little afford the $88 billion price tag for the reconstruction of areas decimated by the Islamic State. So far, it has only received $30 billion for the rebuilding effort after an international donor conference last year in Kuwait, yet most of those funds are in the form of credits and loans that Baghdad must ultimately repay.

Rising oil prices in 2018 allowed Iraq to finally post a budget surplus, thanks to conservative price assumptions and deeply unpopular austerity measures implemented by former Prime Minister Haider al-Abadi. A continuation of this would allow Baghdad to use capital spending to help rebuild some of the damaged areas (indeed, the 2019 budget envisions a one-third increase in capital expenditures), but lower oil prices have put those plans in jeopardy. Prime Minister Adel Abdul-Mahdi has failed to form a Cabinet as political infighting between rival Shiite factions has prevented him from filling the critical posts of defense minister and interior minister. At the same time, Iraq’s sectarian and ethnic composition will also tax its limited ability to rebuild the country and extend services to all citizens. Most of the areas destroyed by the Islamic State are predominantly Kurdish and Sunni, but Abdul-Mahdi will be reluctant to allocate a lot of money to such reconstruction projects, because residents of the country’s oil capital, the southern Shiite city of Basra, have made strident demands for more jobs, more public services and better access to water. In the end, Iraq is likely to witness protests throughout 2019 as the country’s leaders struggle to meet competing demands amid the decline in oil prices.

Venezuela’s Slow-Burning Crisis

In Venezuela, the collapse of oil prices threw the country into a deep economic spiral that will fundamentally alter its economic activities for decades. After prices plunged in 2014, Caracas chose to fund its gaping deficit by expanding its monetary base, fanning hyperinflation. The government slashed imports and defaulted, or fell behind, on virtually all foreign debt payments — even those to crucial creditors such as China and Russia.

Now, Caracas is slowly moving away from decades of relying on oil production for virtually all of its export income. It’s doing so out of necessity rather than choice. With the decline in oil revenue, the government of President Nicolas Maduro is looking for additional sources of funding to keep its political coalition intact with payouts and benefits. Oil production has declined by nearly 1 million bpd since the start of 2018, and other sources of revenue, such as illicit mining, will provide far less income than crude oil exports. This will drive greater competition between Venezuelan elites for revenue from illicit mining and other illegal activities, such as cocaine trafficking. In the long run, this instability will likely claim the Maduro government — and even persist into a new, opposition-led administration.

A U.S. of Winners and Losers

For most of the developed world, cheap oil is a good thing. After all, the European Union, Japan, China and South Korea are all significant net oil importers. And despite rising oil production at home, the United States also remains a large importer for now. More importantly, much of the U.S. economy consumes large amounts of oil, meaning low prices are a boon. At the same time, weaker prices also indicate a relatively sluggish global outlook, which hinders U.S. commercial activity worldwide.

Lower prices in 2015 and 2016 halted North American growth in the production of tight oil; the present drop in oil prices could now lead companies that had been making investment plans when prices exceeded $70 per barrel to curtail those proposals. Already, several shale producers have canceled drilling rig additions in 2019. But many producers took out hedges when prices were high, and production break-even costs in some of the most productive U.S. shale plays in the Permian Basin are $45 to $50 per barrel. This means that while the oil patch could suffer some financial pain if prices remain low, it may not be enough to shut or reduce production overall.

No Guarantees

Three months ago, $90 per barrel of oil was not out of the question, as Brent spiked at $85 per barrel. Prices could quickly rise if there are changes in market conditions, such as the health of the global economy, but they could also remain low if conditions worsen or the U.S.-China trade war deepens. The OPEC+ countries most concerned about oil prices have decided to do whatever it takes to balance the market, including further cuts beyond the reduction they implemented on Jan. 1. Even if this does increase prices, OPEC+ will likely find itself in a similar position to what happened in 2017 and 2018 when prices rose: Higher prices stimulate more production growth in North America, obliging producers to make cuts permanent or deeper to offset strong growth elsewhere. Oil producers may be in for the rude awakening as $50 to $60 per barrel becomes the new normal, and anything outside that range will likely be a temporary blip. And whatever the new normal turns out to be, most countries now have little choice but to shape their economic and financial strategies with that $50-$60 range in mind.


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