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Isabelle Chaboud, Professor in Finance, Accounting and Law at Grenoble Ecole de Management.

On January 18th, 2016, the price of a barrel of crude oil dropped under $29 before coming back up to hover around $30. What factors suggest the price of oil will continue to drop? What geopolitical and economic stakes will be impacted by this drop?

A surplus in the supply of crude oil

Oil production in the USA has increased by 17,000 barrels per day. In many countries, stocks for crude oil distillates have never been higher. The OPEC (Organization of Petroleum Exporting Countries) refuses to reduce its production quota of 30 million barrels per day. For many, this decision is largely due to Saudi Arabia, which wishes to protect its market share and limit the development of shale gas in the USA. In addition, the breaking off of diplomatic relations with Iran has made it impossible to reach a short term agreement to reduce production quantities. Finally, cutting-edge technology has made it possible to extract more oil at a faster pace and deeper than was ever possible even a few years ago.

Chinese demand drops drastically

Demand, on the other hand, has not increased as quickly as hoped. This is in part due to the slow-down of Chinese economic growth. Most indicators concerning the country are still rather worrisome. According to Reuters: “Chinese manufacturing activities have continued to diminish in November and are now at a three year low.” In December, the country’s manufacturing sector was squeezed again for the tenth month in a row. In addition, the devaluation of the yen on January 7th has made oil all the more expensive and therefore limited demand.Fears remain about a possible Chinese stock market crash. On January 11th, the Shanghai Composite index dropped 5% to reach a 20% drop over the last two weeks and a 40% drop since June 2015.

crude oil graph
crude oil graph

Oil price chart, Jan 19 2016. prixdubaril.com

A drop in oil prices would completely modify the global economy. Due to mild winter weather in most European countries, Russia (where the temperature in Moscow was 10 °C on December 22nd) and the USA (where it was 22 °C in New York just before Christmas), oil consumption for heating has also been slow.

New geopolitical stakes

We will focus on the key example of Iran. Oil prices will probably also be forced downwards because of Iran’s return to the international oil market following the nuclear agreement signed in July of 2015. According to a report by the World Bank, the surplus of oil caused by Iranian oil could lead to a drop in the price of crude oil by $10 dollars per barrel. On January 16th, sanctions against Iran were lifted and the country was able to engage in economic exchanges with other countries. Iran confirmed on January 18th that the country’s daily oil production of 2.8 million barrels would be immediately increased by half a million and another million in March of 2016.

According to the website Les clés du Moyen-Orient: “Iran ranks second among OPEC countries, behind Saudi Arabia. The country’s crude oil reserves are estimated to be 132 billion barrels, which also puts the country in second place among OPEC countries.” In other words, Iran’s return will change the current layout. In addition, the end of diplomatic relations between Saudi Arabia and Iran following Saudi Arabia’s execution of 47 prisoners (including Nimr al-Nimr, an enemy of the Sunny state who was closely followed by the Iranians) would appear to suggest that neither country will be willing to reduce its production and might even do everything in its power to increase its market share.

A major economic impact

Oil producing and exporting countries have been hit hard by the 60% drop in oil prices since 2014. Venezuela is on the verge of bankruptcy. Russia has been greatly impacted as oil represents half of its budget and 40% of its exports. According to Reuters: “If a barrel of oil continues to sell for around $30, Russia’s cash reserves will run out within a year.”Kazakhstan, Central Asia’s largest economy, is having to deal with the fact its currency, the Kazakhstani Tenge, lost a quarter of its value in August of 2015. The Kazakhstan National Fund, which is funded by the country’s oil industry, is in charge of developing the country’s infrastructure and industrial investments. The fund’s reserves were estimated at $77 billion in August of 2014, but they are dropping rapidly. According to the Wall Street Journal, the fund only has $64 billion left as of January 2016 and could be completely depleted within six or seven years due to important cash withdrawals from the government.

Norway is also suffering from the decrease in oil prices and its real estate prices continue to drop. Statoil, a Norwegian oil and gas company, has already let go of 20,000 employees. Given that Norway’s oil industry employs one out of nine Norwegians, the country could soon see an increase in its unemployment rate. Norway is on the cutting-edge of technology, a fact the country has to capitalize on by transferring its technology to other industries or exporting it to foreign countries.

Major reforms required

Many countries are affected by the drop in oil prices and all of them should take quick action if they do not wish to face a liquidity crisis or even bankruptcy.Saudi Arabia, whose exports equal 90% of the kingdom’s income, has launched wide-scale reforms. With a deficit of $89.2 billion in 2015, the country was forced to announce a plan for austerity. The government, which greatly subsidizes its water and electricity, has already increased the price of gas by 50% (its gas prices were one of the world’s lowest at around 20 euro cents per liter) and stated that it will reduce subsidies. A VAT of 5% was implemented for non-essential goods. The finance minister is also studying a possible privatization of various companies, in particular the country’s nationalized airways and telecommunications companies.

A long term drop in oil prices completely modifies the Saudi Arabian economy. The kingdom will have to reduce the importance of its public sector while developing its private sector. Even more noteworthy, Muhammad bin Salman, a son of King Salman, mentioned in an interview with The Economist on January 7th, 2016, that Aramco (Arabian American Oil Company) might join the stock exchange. It is not yet clear whether the nationalized company would sell part of its capital or if its subsidiaries would be listed on the stock exchange. But the prince declared that a decision would be made in the following months and he was “personally enthusiastic about this step” which he believed to be in the interest of both the Saudi Arabian market and Aramco.

An Aramco public offering?

The company is considered to be the world’s leading oil and gas company even though the company does not publish its accounts. As a result, it is impossible to have access to its total revenues and reserves. For the moment, there is still a lot of speculation with astronomical value estimations. La Tribune asked for example on January 8th, 2016: “Is Saudi Aramco valued to be worth more than $3,000 billion on the stock market?” In any case, this would create an economic revolution among the super majors (Royal Dutch Shell, Exxon Mobil, BP, Chevron and Total). If an IPO were to take place, it would also inject new money into Saudi Arabia’s public finances and confirm the country’s desire for radical reform. The UAE, Kuwait and Bahrain have also reduced their gas subsidies.

The prolonged drop in oil prices is creating a profound impact with economic reforms. Yet these reforms are still primarily guided by geopolitical or even purely political motivations. Numerous experts were recently still predicting that oil reserves would run out and prices would hover around $100 a barrel. The Chinese economic slow-down, the arrival of Iran and the world’s elevated oil reserves suggest that oil reserves will remain high and oil prices will continue to hover around $30 dollars a barrel, or even drop to $20 a barrel. The result will be a reorganization of political powers.