GLOBAL DYNAMICS OF OIL PRICE RUCHAN KAYA SENIOR RESARCH FELLOW, ENERGY AND INTERNATIONAL RELATIONS EXPERT, HASEN

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1 MESUT RUCHAN HAKKI KAYA CASIN 146 GLOBAL DYNAMICS OF OIL PRICE FLUCTUATIONS RUCHAN KAYA SENIOR RESARCH FELLOW, ENERGY AND INTERNATIONAL RELATIONS EXPERT, HASEN

2 The crude oil saw the lowest price levels since 2009 and has a few economic and political reasons behind the drop. The dramatic increase in the supply side is one of the main factors. Within the past year or so, only one thing is certain about the oil prices and that is the uncertainty of the future price levels. In June 2014, the end of the year price predictions of Barclay s was $109 per barrel. However, by that time, in January, the price was around $50 per barrel. In early 2015 Goldman Sachs and Bank of America Merrill Lynch made even more worrisome price estimates down around $35-45 range in their Q1 projections. However, in early March, the oil prices oscillated Figure 1. Crude Oil Prices in ($) around $55-60 levels and are currently hovering around $65. Looking at these numbers and future estimates, clearly, we cannot predict the price of oil perfectly, but we can identify the reasons of current trend of decline, therefore lowering the amount of uncertainty in future estimations and policy behavior. One of the first things to recognize is that it is important to be aware of the fact that history of oil already includes such price booms and busts. 147 CASPIAN REPORT, SPRING 2015 Source: BP Statistical Review of World Energy, 2014

3 RUCHAN KAYA 148 As Figure 1 shows, recent low prices of oil are nothing new as sharp declines have existed in the past. Although the crude oil price has been increasing historically since 1860s, looking at the adjusted prices with 2013 dollar values, similar price booms and busts appear to have happened in the past. The most recent sharp price decline occurred in Another one was in the 1980s, after historically high levels in 1970s due to two major supply crises. The supply crises that increased the oil prices in the 70s were due to regional conflicts, Arab- Israeli War and Iranian Revolution, respectively. The first crisis emerged because of an OPEC embargo which quadrupled the price of oil from $3 to $12 per barrel in about six months, starting late 1973 and ending in early The second crisis was also a supply crisis due to the Iranian Revolution in Figure 2 demonstrates the decline in supply levels. The Iranian production fell from 5.3 million barrels per day in 1978 to 1.5 and 1.3 barrels per day in 1980 and 1981, respectively. This sharp decline in production levels more than doubled the crude oil price, rising from $14 per barrel to over $30 levels. Figure 3 displays world oil supply as well as the variation in regional production levels and shows the decline in production from 66 million in 1979 to 56.6 million barrels per day in Although the prices have soared immensely following these two international supply crises of the 70s, over the course of a year, the oil prices once again have decreased from $27 per barrel in 1985 to $14 in The levels of $27 per barrel did not reach to the same levels until the 2000s. As Figure 1 displays, $27 at the time of the Iranian Revolution was almost equivalent to the astronomic levels following the Iraqi war. The main reason for such price decline in the 80s was oversupply in the market which attracted non- OPEC producers to increase their production. As Figure 3 shows, non- OPEC production was around 19 million barrels in 1972 and reached up to 25 million in In terms of the market share, non-opec production was 36 percent in 1972 and reached up to 51 percent in Figure 2. Oil Production in Iran Source: BP Statistical Review of World Energy, 2014

4 Figure3. World Oil Supply by Regions and Groups (barrels per day) Source: BP Statistical Review of World Energy, 2014 POTENTIAL REASONS BEHIND THE FALL OF OIL PRICES The crude oil saw the lowest price levels since 2009 and has a few economic and political reasons behind the drop. The dramatic increase in the supply side is one of the main factors. While Libya already quadrupled its production levels after the sharp decline during the Arab Spring, Iraq increased its production with new investments. Beyond these two countries, by improving shale oil production, the US increased its production capacity from 6.8 million barrels to above 10 million barrels per day while more than doubling domestic rig count within five years. In total, world production of oil has increased from 81.3 million to 86.2 million barrels per day from 2009 to While global oil supply has increased in the past few years, economic growth has plummeted. After picking up with growth following the negative effects of the 2008 global financial crisis, growth rates have decreased again especially among the developing countries. Within the BRICS countries, which usually drive the energy demand, the economic growth rate has slowed down after 2010 and in turn the oil demand has experienced a decline as well. Although the price decline has been hurting the revenues of the producers, there are a few reasons behind their refusal to cut back production, especially driven by Saudi Arabia and the Gulf states. The official position of these countries is not to lose their market share to rising Iraqi and Iranian production. Among these countries, especially Saudi Arabia is unwilling to cut back production. However, according to BP figures, it has been consistently increasing the production levels since 1985, rising from 3.6 million to just below 11.5 million barrels per day in In terms of the share of the market, Saudi Arabia accounted for 6 percent of the world oil production in 1985 and increased its share since then, currently accounting for CASPIAN REPORT, SPIRING BP Statistical Review of World Energy 2014.

5 RUCHAN KAYA 150 percent of the world supply. Therefore, the claim that the country does not want to lose its market share is rather unwarranted; rather, pushing for more market share seems like a better description. Another economy based claim, attempting to bankrupt producers with higher break even costs is a more plausible explanation. The Saudis have very low production costs ($4-5 per barrel) compared to their competitors in North America. Furthermore, having Sovereign Wealth Funds over $800 billion, the country has the luxury to sustain lower crude prices despite losing substantial export revenues. THE CONSEQUENCES OF LOWER PRICES Russia Being a major oil producer in the world, Russia is also one of the main losers of the current oil price bust. The Russian finance minister estimated a loss of around $100 billion a year when oil prices were around $76 at the end of November last year. Since then the prices kept going down further and currently for 2015, IEA expects the oil price to range around $55 per barrel. With such estimates the Russian financial loss from the oil prices could go up to $183 billion for 2015 due to the decline in oil prices. Furthermore, Gazprom s natural gas contracts are tied to oil prices, mostly with a six-month lag. 2 Because of these agreements Gazprom and Russia will experience the negative effects of the price shocks with a six month delay. Russia is one of the largest oil producers in the world with a capacity of 10.8 million barrels per day and the largest natural gas exporter with 225 bcm export in Oil and natural gas revenues also account for more than half of the Russian state budget. Therefore, relying on such natural resources as primary source of income not to mention the financial loss due to the Western sanctions over Crimea annexation- will exacerbate the consequences of the falling oil prices on Russian economy. North America Although the United States is one of the largest oil producers in the world, unlike Russia, it is also one of the major winners of low oil prices, especially on the political side of the spectrum. Domestically the consumers enjoy lower gasoline prices. EIA estimates an additional $750 savings per household due to cheap gas while families which use heating oil may enjoy another $750 advantage over the year of This is a major boost for lower and middle income families and a major political advantage for the current administration. Internationally too, US is able to hurt its global adversaries like Russia, Iran, and Venezuela through lower prices. A similar strategy was followed in the 1980s where Saudi Arabia started to increase its oil supply dramatically, helping to lower the price of oil in order to hurt Iran-- and also the Soviet Union. At the time these pricing policies of the Kingdom received criticism from bin Laden who wrote a letter to King Fahd and accused him for serving American interests and consumers while hurting the Saudi economy. 3 Unlike the United States, its northern neighbor, Canada appears to struggle as the price of oil plummets. 2. Kramer Gamal and Jaffe p. 66.

6 With high oil prices and the availability of new technology, Canada invested over $150 billion in oil industry and now struggling due to low oil prices. The Canadian central bank lowered the interest rates and the currency depreciated close to 20 percent. Given the current situation, the already unpopular conservatives might lose the federal elections after 9 years in the upcoming elections in October 2015 if the price of oil stays this low. Looking Ahead It is hard to predict the direction of the volatility in oil prices. Even the major players in the markets fail to make healthy short or long term predictions. However, taking lessons from the history might help us better understand the political and economic dynamics behind such drastic price fluctuations. Looking at the major price declines in the past, Figure 1 displayed how similar ups and downs have happened in the past. However, these fluctuations had different dynamics like supply crises, oversupply, major political disagreements or wars. The current price decline seems to be a product of oil glut which is similar to what happened in the 80s. The question is whether major oil producers will continue to fight for market share and force to bankrupt small drilling companies or agree to cut back the supply in the short term. For now the latter appears to be a far-fetched idea. Another possibility is a potential increase in oil demand through a financially healthy Eurozone and growing BRICS economies. 151 CASPIAN REPORT, SPIRING 2015

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