Reversal of fortune

An O&G Special Report

Oil is one of the biggest casualties of the global economic downturn with prices crashing from US$148 a barrel in July 2008 to less then $50 today. We report on the impact this will have on MENA oil and gas producers and their economies.

Oil has been and will continue to be used as a political weapon

“We are in a crisis. The price of oil has reached levels that OPEC members want to see improve”
-OPEC President Jose Maria Botelho de Vasconcelos

Six months ago few could have predicted that oil producers would suffer such a dramatic turnaround of events. Oil had reached an all-time high of US$147 a barrel providing abundant liquidity to fund record-breaking infrastructure projects across the Gulf. So optimistic were analysts about the future global demand for oil that Goldman Sachs predicted prices could reach up to US$200 a barrel in 2009. This year however, as the global financial crisis deepened, the first drop in oil demand for 25 years caused prices to plummet.

The extent to which Goldman Sachs later changed its estimate illustrates just how unpredictable the situation has been. In December it dramatically slashed its prediction for the price of oil in 2009 to just US$45. It also stated that OPEC should introduce a more “severe” reduction in oil output in order to stimulate the market.

OPEC did reduce output – announcing plans to cut 2.2 million barrels daily starting on January 1st. However, news of the cut did nothing to curb the relentless plummeting of oil prices. Shortly after the announcement, Goldman Sachs’ prediction was realised earlier than expected – oil tumbled to below US$40 a barrel with US light crude for January delivery falling to just US$39.64 a barrel. Even gloomier predictions have been made by US bank Merrill Lynch which claims that oil could reach a low of US$25 a barrel before it recovers. A research report published by the bank in December stated: “With demand vanishing across all key oil consuming regions, benchmark crude oil prices continue to plummet. In the short-run, market participants will focus on both OPEC and perhaps even non-OPEC producer responses to balance the market.  A temporary drop below US$25 is possible if the global recession extends to China and significant non-OPEC production.”

OPEC itself has released gloomy predictions for the levels of oil demand – and how these will dictate prices. In its monthly oil market report published in December it stated that demand for its crude is expected to fall by an average of 1.4 million barrels a day (bpd) with the first half of the year seeing an even steeper decline: “Given negative growth in world oil demand and positive growth in non-OPEC supply, the demand for OPEC crude is projected to decline sharply in 2009, falling 1.4million bpd to average 30.2 million bpd,” the report stated. “Moreover, in the first quarter of 2009, the demand for OPEC crude is expected to see a sharp drop of 2.3 million bpd from the same quarter in the previous year.” The reliance of the Gulf countries on oil wealth to fund their economic growth means the impact of these price drops could be potentially catastrophic – particularly for those that were relying on high oil prices to fund ambitious infrastructure projects.

The World Bank’s 2009 Global Economic Prospects report predicts that growth in the Middle East region will slow to less than 4% in 2009 – 3.9% compared to 5.8% in 2008. It stated that while a rise in oil and natural gas revenues to US$200 billion in 2008 funded economic growth – the same would not be true for 2009. The decline in investment in the region would create the biggest impact, the report warned, which claimed this could decline to 3.4% in 2009 compared to a high of 13% in 2007.

The reality on the ground of these changing conditions is that Gulf business and political leaders have been forced to re-think projects and economic growth targets. The hardest hit country, according to the International Monetary Fund (IMF), could be Saudi Arabia. It claimed in October that if oil prices dropped below US$49 a barrel, the country’s budget would be in the red.

The most likely projects to be affected by the lowering of oil prices are those associated with the energy sector. Already Saudi Aramco has tightened its belt, having cancelled a project to re-start production from the Dammam oil field which would have generated an extra 75,000 barrels of crude oil per day. It has also delayed bidding for the Yanbu refinery, due to generate 400,000 barrels per day, in partnership with ConocoPhillips. This was due to take place from the fourth quarter of 2008 but will start in the second quarter of 2009 instead. Meanwhile in Qatar the country’s oil minister warned in December that if oil prices stay under US$70 several of the projects which were launched to boost the country’s energy sector could be delayed. Speaking to a petrochemical conference in Dubai, he said: “My concern is that the oil price will go lower and many projects will be delayed.” He went on to say that this could lead to supply shortages in the long term when the demand picks up again.

The fact that many of the Gulf countries’ infrastructure projects were funded through oil wealth means these too could be affected. Although the IMF claims that the UAE will not post an account deficit until the price of oil drops to US$23 a barrel, it is particularly vulnerable to the effects of price falls given the scale of the infrastructure projects it has invested in.

The UAE’s economic growth is predicted to drop to 6% this year, down from 7% last year according to the IMF and there are already signs that infrastructure projects are being scaled down. Nakheel, the master developer behind the Palm Jumeirah and The World islands has announced plans to scale back activity around some of its projects and has made 500 of its staff redundant. Meanwhile, developers Emaar Properties and Damac have both announced job cuts.

The Saudi government has claimed that its planned infrastructure and real estate developments will remain on schedule. However, as the country with some of the most ambitious projects in the region – including King Abdullah Economic City which is being built near to Jeddah at a cost of US$120 billion – its modernisation plans could be hit hard if oil prices slide further.

Kuwait has been the most open about the effects that falling oil prices could have on its infrastructure projects.  According to Citigroup, Kuwait would be the only country in the GCC to still have a budget surplus if oil averages US$50 a barrel. However, the country’s government has stated publicly that it is scaling down its growth plans because of the price drop.

Experts are still unable to predict the full extent of the global financial crisis and just how far demand for oil will fall. Some have suggested that oil prices could pick up again later this year and even return to July 2008 levels – by 2010-2011. Speaking at a conference in Warsaw late last year, the Chief Economist of the International Energy Agency (IEA), Fatih Birol said, “We can see almost everyday that projects are being cancelled (due to the financial crisis) and this is bad news as supply is being withdrawn, but demand will eventually rebound in 2010-2011. We may see prices going even higher than we saw this summer,” she went on to say. A research report by Merrill Lynch claimed prices could start to climb again next year once economic recovery begins. “In our view oil prices could find a trough at the end of Q1 2009 or early Q2 2009 with the seasonal slowdown in demand. Then, as economic activity starts to strengthen, we see oil prices posting a modest recovery in the second half of 2009.”

While these claims will go some way to reassuring oil producers, the instability of the world economy means it is impossible to predict the recovery of oil prices with any certainty. The repercussions of falling prices for GCC countries prove the fragility of economies that rely so heavily on the energy sector – and the need for them to develop sources of wealth beyond oil.

Oil, oil, toil and trouble

Fadel Gheit, Senior Oil and Gas Analyst at Oppenheimer, gives his take on the turmoil in crude prices and accuses some producers of making some ill-judged decisions
Today, everybody is extremely worried about banks and financial institutions; nobody is concerned about oil companies. Oil companies have always been in very strong financial shape. They have never had low work debt on their balance sheet as they have now, but the future is uncertain. It is a double-edged sword. They have record earnings, but yet most of their stocks are trading, or at least sustaining, the biggest drop in history. The market is confused because of all these changes that are happening very rapidly, the prices are not reflecting supply and demand fundamentals.

Up or down?

There is tremendous speculation in the marketplace. Most investors have no place to go, so they are bidding out commodities and oils. You can see the indecision, the confusion, the chaos, the lack of leadership, the little faith in government decision and officials, and all these things are factors that will have a long-term impact on the whole industry.

We need speculation in any market; we all speculate, but these speculators are those financial players that have no intention whatsoever in owning the physical commodity. Excessive speculation is harmful and exaggerates movement in the price of commodities, forcing companies into making decisions that are not good in the long term. When oil prices were US$148, many companies made decisions that they will live to regret a year or two year from now because oil prices are not sustainable at US$148. We are going to see the impact of high oil prices on consumer spending and inflation. It also hardens the imposition of the national oil companies, which is why we have limited access to resources – because most of the companies that own the resources are in no hurry to open access as there is no compelling reason for them to allow foreign oil companies access. These companies make a great deal more money by producing less oil than if they were to allow oil companies to come and develop and increase output. We are seeing that happening with BP in Russia; we’re seeing that happen in Venezuela.

Having been in the business more than 25 years I am no longer surprised to see anything happen in the oil market. People don’t realise that the oil markets are not free markets. They are far from free, because more than half of oil supply in the world is coming from OPEC and Russia. By definition when you have a cartel controlling more than 25% of a commodity, there is no free market. On the other hand, the demand for petroleum product is also not free. Why? Because of taxation. On the supply side, it is distorted by a cartel; on the demand side, it is distorted by taxation and subsidies.

Government greed

It seems like too much of a good thing is a bad thing. And now people are thinking that maybe we should put additional taxes on oil and gas companies. In Russia, oil companies were losing money when oil was US$100 but they were making money when oil prices were US$35. Why? Because Russia has a US$35 per barrel tariff that is flat. The owners imposed this tariff a few months ago, and by the time you incorporate the production and transportation costs, as well as the very high effective tax rate, and then hit them with US$35 tariff, at the end of the day they actually lose money. Now, Russia wants to cut this tariff in half to get them decent profits of around US$5 or US$6 per barrel. This is because government greed increased  significantly with the rise in oil prices.

This is happening all over the world. On one hand, the government of both the consuming nation and exporting nation blame oil companies, but they are also causing the problem because the consuming nations are putting huge taxes on motorists using gasoline and diesel, and taking a huge amount of profit away from oil companies in the form of taxation and royalties, and the exporting countries are milking oil companies to the last drop they can get their hands on. Oil has been and will continue to be used as a political weapon. It is not a free market, it does not reflect supply and demand fundamentals, and basically it is creating a lot of mess around what is happening in Russia, Venezuela, Nigeria and Iraq; if it were not for oil, we would not be in Iraq. We have no interest in Afghanistan because it doesn’t have oil, but we are more interested in Iraq because Iraq does.