June 9, 2016
A Crude Bargain
By Hossein Askari
Executive Board Member of the International Monetary Fund and former Special Advisor to the Minister of Finance of Saudi Arabia

Why oil will stay below $60 per barrel for at least the next decade.

Oil price forecasting is a difficult game. Some observers think that the price moves in only one direction – up or down, but not up and down. Still others seem to think that the more they repeat their prediction, in public or in front of the mirror, the more likely it is to come true.

In 1979, during the Iranian Revolution, prices were predicted to explode, with OPEC countries piling up enough wealth in a matter of a few years to buy all publicly traded shares on the U.S. exchanges. But, after rising for about two years, prices declined and remained stagnant for nearly two decades (with a short-lived spike when Iraq invaded Kuwait in 1991).

Some then predicted permanently low oil prices and the collapse of oil exporting countries. But, forecasters were off the mark as prices rose to their highest nominal level to date, reaching more than $145 a barrel in 2008 with some oil ministers predicting prices surpassing $175 a barrel. Instead, prices fluctuated and then went down to a little over $26 a barrel on Feb. 11, 2016 – and with oil experts joining the bandwagon and predicting even lower prices of below $20.

In my view, the combination of market forces and the respective interests of Iran and Saudi Arabia will mean that the price of oil will generally remain below $60 a barrel for the next decade.

Oil prices are determined by the interaction of the market forces of demand and supply.

Demand for oil, as in the case of many other products, is in large part determined by the price of oil, and secondarily by global economic growth, the price of substitutes for oil and factors such as weather; and, of course, there is the short- and long-run impact of factors such as conflicts and wars on the demand for oil (and, more importantly, on its supply).

The supply of oil is also determined by the price of oil; up to about four or five years ago, some very smart people talked about the approaching “peak oil,” or a physical limit to ever increasing production, but even that balloon was popped by the emergence of shale oil; and others today are predicting a peak in the demand for oil as renewable sources of energy replace hydrocarbons.

The most unusual factor in the evolution of oil prices is the declining market power of large oil producing countries. From 1980 to 2015, Russia and especially Saudi Arabia could unilaterally move oil prices on a sustained basis by cutting or increasing output and exports. Markets were tighter and Saudi Arabia was the only country with significant excess capacity and a strong financial position, so it could increase or decrease exports and, thus, control prices.

Today, things are different. Shale oil (and gas) production and slow world economic growth have created a global oil glut of about 1.5 million to two million barrels a day (b/d) that looks to be around for at least a few years; Iran is free from sanctions and will do all it can to attract foreign investors to increase output dramatically; Iraq plans to increase its output even further if it can restore political stability; and Saudi Arabia may be expanding its own sustained production capacity by about another two million b/d over the next 3-5 years because the rulers believe that the economic lifespan of oil as an energy source may be no more than 25 or so years.

All of the above notwithstanding, the conditions within Saudi Arabia and Iran, and the relationship between the two, will have a material impact on oil prices for the foreseeable future.

For the rulers of Saudi Arabia, the Al-Sauds, the overriding goal is to remain in power; everything else is secondary and pales in comparison. The Al-Sauds see the country as “theirs” and they intend to keep it that way. They have used the country’s vast oil wealth to buy the citizenry (excluding their 12-15 percent Shia citizens) and the support of the corrupt religious hierarchy. Wasteful subsidies, heavy military expenditures, corruption, generosity to foreign supporters and the active obstruction of effective institution building have had a deleterious effect on the development of a thriving private sector and building a large and well-managed sovereign wealth fund to provide equitable benefits to future generations of Saudis.

While reforms are essential, they will be politically challenging and will cause a backlash from different segments of society: business interests, the ruling Al-Saud family, those with lucrative government jobs, the religious establishment, and especially the general citizenry who lose the handouts afforded to previous generations as a birthright.

In conjunction with their paramount goal of survival as the rulers of Arabia, the Al-Sauds have an overriding fear that the regime in Tehran is determined to overthrow them. Thus the Al-Sauds will do nothing to help and everything to weaken the regime in Tehran. They see oil prices as the most effective weapon in their arsenal to keep Iran at bay and thus if low oil prices reduce Iran’s oil revenues then it is the weapon of choice.

The mullahs of Iran want to stay in power, too, but their background and conditions are very different from the Al-Sauds. They don’t see Iran as theirs. They realize that Persian heritage and history is bigger than the mullahs. They had lost power and wealth under the Shah and they have regained both to a bigger extent than they had thought possible in their wildest dreams. The religious establishment recognizes that it needs the Islamic Revolutionary Guard Corps (IRGC) to rule; if the IRGC wanted to assume power there is nothing they could do about it and the IRGC could easily take over the reins of power. But the mullahs see the IRGC as a part of the Revolution and a takeover would not drastically damage their position.

The focus of Iran’s oil policy is purely commercial – deliver maximum oil revenue to keep all constituents as happy as possible in order to stay in power. But Iran does not fear the Saudis or the other countries of the Gulf Cooperation Council (GCC) to use oil and oil prices as a weapon to affect revenue. The mullahs have no desire to overthrow the Al-Sauds per se, but they would like to re-establish Iran’s dominance over the region and among the Shia worldwide, and show all Iranians that they have restored Iran’s position in the wider region beyond anything that the Shah had achieved – they see this as the best way to guarantee the Revolutionary regime’s (mullahs, the military and the intelligence services) long-term survival.

Iraq potentially could have as much, if not more, oil as Saudi Arabia. Iraq’s political turmoil does not invite sustained development of all oil fields. Until stability is restored, Iraq will be about where it is today, but a big increase in Iraqi production is always a threat to other major suppliers and, depending on the eventual political outcome, a potential ally of Iran in all spheres.

How will all these interests and relationships play out in the future and how will they affect oil price developments along with expected market developments in supply and demand?

On the demand side, world economic growth will not go back to its trend before the Great Recession. At the same time, growing concerns about global warming will begin to have a significant impact on national policies and personal choices. Electric and natural gas-powered vehicles will become a more significant part of the global vehicle fleet. All renewables are likely to make an increasing contribution to the global energy balance. The combination of these will slow the growth in oil demand.

On the supply side, I believe that there are strong forces indicating plentiful supplies. The shale oil revolution, so underestimated by experts, is here to stay and may in fact expand; yes, there will be production shutdowns as prices decline but given the sunk costs and depending on the location and financial condition of the shale oil producing entities when oil hits $55 a barrel, they will start coming back on line; and shale oil and gas production around the world (i.e. outside the U.S.) will be developed and begin to climb.

Iran, Iraq, and Saudi Arabia will all increase their production levels. Iran will do all it can to ramp up production output to more than seven million barrels a day (from 3.6 million in March) and exports to over 4.5 million b/d (from 1.75 million in March) over the next 5-7 years. If Iraq can achieve political stability, it could increase output to eight million b/d (from 4.5 million in March) and exports to 5.5 million b/d (from 3.8 million in March). And Saudi Arabia is likely to increase its sustained production capacity by about two million b/d (to about 12.5 million b/d) over the next 3-5 years.

If market conditions were not enough to dampen oil price expectations, there are also the political realities mentioned above. Namely, while oil output and exports are important to the Al-Sauds, it is trumped by their survival instincts. Being totally convinced that the regime in Tehran is set on their destruction, they will not do anything that could help the mullahs. It is the principal constraint that encourages maximum Saudi oil output now and an increase in installed oil production capacity of about two million b/d over the next 3-5 years to afford Saudi Arabia continuing market power and to get oil out of the ground faster. It is these Saudi motivations that impose the operative lid on oil prices for the foreseeable future.

Putting it all together, I cannot see oil prices (West Texas Intermediate crude) going above $55 to $60 in at least the next decade. The only exception might be short-lived jumps as a result of conflicts and disruptions.

Hossein AskariHossein Askari is the Iran Professor of Business and International Affairs at the George Washington University. He served on the executive board of the International Monetary Fund and was special advisor to the Minister of Finance of Saudi Arabia. He was the director of an international team of energy experts that designed the first energy plan for the government of Saudi Arabia in the mid 1980s. He has served the governments of both Saudi Arabia and Kuwait as an intermediary to improve bilateral relations with Iran; and has assisted US companies to settle disputes with the government of Iran at the Iran-United States Claims Tribunal in The Hague.