Saudi airstrikes in Yemen. An incoherent war on the Islamic State. A chill wind blowing away trace memories of an Arab Spring. And now, a framework nuclear agreement with Iran.
A region that can simultaneously set the direction of the global economy, global politics and global climate has rarely seemed as full of contradiction: breakthrough is juxtaposed with impasse, conflict and failure. Of course, aside from the historical and geopolitical significance of the Middle East, the key link between the region and the world is through its sway over oil supplies. Yet, oil markets have been notably muted in their reactions to the turbulence of the region. Even when prices spiked on concerns that shipments through the Bab-el-Mandeb Strait would be disrupted by the Yemeni crisis, the progression of the nuclear deal with Iran acted to send them back down. What is going on? Is the Middle East’s outsized influence on oil a thing of the past? Can we bank on cheap oil forever? Does the prospect of an agreement with Iran ensure that oil prices will fall further, making the region’s uncertainties irrelevant? Prepare to be surprised.
As with any market, uncertainties lurk on both the demand and the supply sides. The issues on the demand side of the oil markets are mostly outside the region: the future trajectory of the Chinese economy, international agreements over reductions of greenhouse gas emissions, the value of the dollar etc. On the supply side, in the old days, the oil producers presented a faithful facsimile of the prisoner’s dilemma game: a mutually destructive outcome of price wars among competing commodity producers being held in check by an inherently shaky cartel, with eight out of 12 current members from the Middle East. In the past year, the game has changed in dramatic ways. There are at least three parallel game boards perched on the global oil platform. The independent uncertainties on each game board compound the uncertainty for oil prices overall.
Game board one: the sheikh versus shale standoff. Thanks to the unrelenting campaign by the Saudis, Opec, the shaky cartel in question, recently stood up to its newest competitor: the upstart North American producers scouring shale and tar sands for “tight oil”. Opec’s solidarity in not curtailing supplies has set up a game involving sheikhs vs shale, to borrow from The Economist’s recent cover headline. By tanking oil prices, the Saudis hoped to slow US shale production by making it uneconomical for the marginal producer. Indeed, new well permits for North American shale oil and gas fell 40 per cent in November, after the Opec decision.
Of course, this is a dynamic game. The US Energy Information Administration noted that, since November, US crude production rose to 9.42 million barrels per day — the highest level since 1973, despite the fact that, according to Baker Hughes, there were 825 active oil drilling rigs in the US, down from 1,473 rigs a year ago. What happened? The US producers’ counter to the Saudi/ Opec gambit was to become more productive. They employed more efficient techniques, putting greater pressure on suppliers and technologies such as “pad drilling”, which allowed them to drill more wells with fewer rigs. The result: uncertainty about the future of oil prices.
Game board two: the Putin vs Pax Americana standoff. In the meantime, another major energy producer, Russia, is playing a very different game. As self-appointed grandmaster, President Vladimir Putin has kept his motives and desired endgame hidden from view. How far will he go in his current aggressive gambit of territorial expansion? Is his objective limited to controlling the Black Sea region and owning the corridor through which European energy supplies travel or does he have grander ambitions? Alternatively, is it possible that he has no endgame in mind and is behaving out of pure instinct or just plain irrationality?
In the near term, regardless of Putin’s motivations, one thing is quite clear. It is in his interests to ensure the status of oil and natural gas as a strategic weapon. Since about half of the Russian government’s tax revenue comes from the oil industry, tighter oil supply and higher prices contribute to the Kremlin’s strategic arsenal and bottom-line. Russian indiscipline and opacity of motive should be factored into continued uncertainty about the future of oil prices.
Which brings us to a consequence of the Iran deal. Game board three: the Sunni vs Shia standoff. The Iranians were no fans of the Saudi manoeuvre on game board one. Iran’s Supreme Leader, Ayatollah Ali Khamenei, had tweeted, “crashing oil prices… is a blow against Islamic and independent nations”. Regardless of the logic of slowing shale production, there is a deep ideological division within Opec, to which they both belong, the Saudis having assumed leadership of Sunni Islam and Iran claiming leadership of Shia Islam. To add to the divide, the two countries have very different capacities to absorb a fall in the price of oil. Hydrocarbons make up 60 per cent of Iran’s export revenue and accounted for 25 per cent of its GDP in 2013, while the Saudis can bank on $741 billion of currency reserves and had a $15 billion surplus at the end of the last fiscal year.
Iran has an interest in challenging the Saudis wherever it can. The lifting of sanctions can add to Iranian confidence to take on the Saudis. With Iran’s enhanced influence in Lebanon, Syria, Iraq and, most recently, Yemen, its Supreme Leader now has more leverage as he can threaten oil transport throughout the region and put upward pressure on prices. Even though the impending nuclear deal means more Iranian supplies in the international market, the Sunni-Shia rivalry and asymmetric interest in higher oil prices could drive a wedge within Opec and create uncertainty. In effect, the US-led nuclear deal with Iran gives the latter more pieces on the chessboard to play with and contribute to a showdown with the Saudis.
The net impact? Oil markets were notoriously hard to call in the past. Yes, we may be luxuriating in cheap oil in the near term, but the Iran deal has just confirmed a third game board on the oil platform, whose outcome may be hard to call. Yes, it is indeed time to prepare for inevitable surprises. The party could end sooner than you might think.
The writer, senior associate dean of international business and finance at The Fletcher School at Tufts University and founding executive director of Fletcher’s Institute for Business in the Global Context, is author of the book on the game theory of innovation, ‘The Slow Pace of Fast Change’.