Ready for the return of the $150 per barrel oil price?

Back in 2008, the crude price reached $147 per barrel before the onset of the global credit crisis, which pushed the price down to $135 per barrel. Recent increases in oil prices, in spite of the uncertain outlook for the global economy, came mainly because of escalating tensions between the West and Iran over the latter’s nuclear programme. Over the past few weeks, EU leaders have agreed to an embargo on Iranian oil to be phased in over six months. In response to tighter sanctions, Iran is threatening to block the Strait of Hormuz, through which one-sixth of the world’s oil and large quantities of natural gas pass. In a further escalation, Iran reportedly threatened to cut off oil supplies to France, Greece, Italy, the Netherlands, Portugal and Spain. Subsequently, Iran’s said that it had ceased sales to “British and French companies”. The key concern now is how Iranian sanctions and retaliatory action will affect oil markets and prices in the coming weeks and months?

Firstly, let’s examine the most plausible scenario, in which an EU ban goes ahead until imports are cut off by July 1, as European leaders have agreed. This will erase the supply of about 450,000 barrels per day (b/d) to Europe, forcing Iran to seek buyers elsewhere. The EU accounts for 18 per cent of Iranian oil shipments, while the most important markets for Iranian oil lie in Asia. China alone buys 22 per cent of Iran’s oil exports and is Iran’s biggest customer. It is anticipated that Iran’s crude exports will flow eastward in greater quantities. In any case, market analysts expect that Iranian oil output will fall by 300,000 b/d due to the European sanctions. Meanwhile, as is widely assumed, the job of making up for the shortfall of supplies to European refineries will fall to Saudi Arabia.

Saudi Arabia has most of the world’s spare oil-production capacity. The US Energy Information Administration estimates that total spare capacity in oil output stands at around 3 million b/d, with the world’s remaining spare oil-production capacity spread around the Gulf.  To this end, Saudi Arabia’s oil minister, Ali al-Naimi, asserted that his country would be able to fill any gap left by Iran in the event of sanctions. Saudi Arabia can lift production from around 10 million b/d to as high as 11.8 million b/d within days, he said, and hit 12.5 million b/d within three months. So long as the effect of sanctions on Iranian oil is limited mainly to Europe, however, Saudi Arabia will only need to tap around a quarter of its spare capacity.

However, even in this scenario, oil markets will not likely adjust seamlessly to sanctions, as there will inevitably be some disruptive consequences for oil markets. For one thing, the Saudis could find it difficult to judge how big a gap in supply must be filled. If Saudi Arabia floods the market with too much oil suddenly, prices will drop. Downward pressure could also come simultaneously from Iranian efforts to sell oil on the cheap. Sagging prices would harm the export earnings of not just Saudi Arabia, but others in Opec.  It is likely that Saudi Arabia will be keen to avoid triggering this effect.

On top of this, Russia could give Saudi Arabia some additional competition, as it releases supplies for Europe. It is possible that Europe might turn to Russia for more oil, especially since Russian supplies do not need to pass through the Strait of Hormuz. On the other hand, Europe, already uncomfortably dependent on Russia for gas, will be reluctant to become more reliant on Russia for yet more hydrocarbons. It could also look to African countries such as Angola and Nigeria for oil. If, as a consequence, Saudi Arabia found that not all its extra output was required in Europe, it would be forced to try to sell some of this to Asia. But this would bring it into competition with potentially discounted Iranian oil.

In the worst-case scenario of the highly unlikely closure of the Strait of Hormuz or a Western bombardment of Iranian oil facilities, the situation would become far more complicated. Blocking the Strait of Hormuz would prevent 15 million b/d from reaching buyers, mainly in the Asia-Pacific region. Saudi Arabia would struggle to help fill this gap: it would not be able to transport most of its own exports, since alternative routes are scarce. On the brighter side, although nobody would be able to tell how long the Strait would be closed, it is safe to assume that Western powers would try to force the route open again as quickly as possible.

If, on the other hand, a Western bombardment put all of Iran’s oil facilities out of action, Saudi Arabia could be asked to plug the gap. Yet it would be reluctant to pump into the market all the extra oil that it claims to be capable of producing (2.5 million b/d) for fear of being unable to respond to further disruptions. In fact, no matter how generously Saudi Arabia acted, global spare capacity would be inadequate to make up the shortfall from lost Iranian production. The International Energy Agency would thus come under pressure to release strategic stockpiles onto the market.

Such calamitous scenarios are, in any case, extremely improbable because Iran’s unilateral closure of the Strait of Hormuz would cut off a crucial lifeline for its own economy, which is already in desperately poor shape. Western powers, themselves struggling with economic turbulence, will be extremely reluctant to bomb Iran’s oilfields and unleash havoc on oil markets. Therefore, both sides have ample incentives to stay away from the brink.

Nonetheless, uncertainty over the threatened closure of Hormuz, no matter how unlikely, and worries about the mechanics by which Saudi supply would replace Iranian oil in Europe, will keep upward pressure on oil prices. Based on the Oxford Macro-economic Model, if we make the worst-case scenario of oil price increases to $150 per barrel, this would push down global economic growth from an already-benign 2.4 perc ent to 2.1 per cent in 2012. Thailand would certainly feel the pinch, as our domestic economy depends heavily on oil imports, with economic growth reduced to 3.9 per cent in 2012 from the baseline growth of 5.0-5.5 per cent.  

Given the uncertain geo-political scenario outlined above, it is likely that the recent spike in oil prices will be sustained in the coming months as the tension continues. In any case, we can expect a high level and high volatility of energy prices in the coming weeks and months. Looking ahead, it is time we all re-examined our energy policies to ensure adequate energy supply and to promote efficient energy utilisation in the coming years.

 

Dr Chodechai Suwanaporn is executive vice president, economics & energy policy, PTT Public Company Limited. ([email protected].)