Monday, 4 April 2016

Dropping Oil Prices: An Alarm for Saudi Arabia

The continuous drop in oil prices is a threat for Kingdom Saudi Arabia as their economy is highly dependent on oil. If the kingdom would do nothing about it, they may run out of money by the year 2020 as anticipated by John Mauldin who is the chairman of Mauldin Economics. According to Mauldin the kingdom is taking appropriate steps to stay submerged however, they are acting like a company rather a kingdom in this matter. The kingdom has to realize that they are not company after all. The population will be greatly affected if they will continue the Federal cuts on spending. Those who work for the government would be adversely hit and surprisingly almost 90% of the people in the kingdom are working for the government.

Now the question comes why there is such drastic drop in the oil prices anyway?

It is simply due to the change in demand and supply phenomena. As the supply and demand of certain product affects its price, the lower would be the demand, the lower would be the price or otherwise, the more will be the supply, the lower will be the price.  Here comes the point that whether the demand of oil has been decreased or the supply has been increased so that Saudi Arabia is facing a difficult situation?

In order to understand this we first have to take a look at mid-2000s when the oil prices were rising in a very sharp manner because there was a surge in the global demand especially by the countries like China and there was not enough of the oil supply to meet the growing demand. This led to an increase in the oil prices and the oil price drifted around $100 per barrel during 2011 to 2014. With an increase in the oil prices many companies found this business profitable and started exploring and extracting oil. They even started drilling at the most difficult places. In United States the companies started using fracking and horizontal drilling techniques in order to extract oil from Texas and North Dakota. Similar was situation in Canada where the oil companies begun to heat gooey oil sands of Alberta with intense steam in order to extract the crude.

This situation led to a great boom in the constricted oil production. The United States alone contributed around 4 million new oil barrels per day to the international market since 2008. The global crude production increased significantly up to 75 million barrels per day. However, this boom in the US oil production did not bring much of the significant impact on global oil prices. The reason was that United States and European Union put oil sanctions on Iran whereas, Iraq was fighting external war with US and Libya was under severe civil war. Hence even though supply increased in one zone of the globe, at the same time it decreased from the other part of the world.

The tables turned after mid of 2014. There was an ease in the sanctions that were slapped earlier. By July the rebels in Libya opened two main export terminals that had been shut closed for almost a year. This raised the oil exports of Libya radically. During this time the oil demand dropped in Asia and Europe. Mainly China and Germany decided to slow down their demand. United States that was once considered to be the largest oil consumer faced greater cutbacks in oil industry due to recession in the economy. Moreover, countries like Iran and Indonesia decided to cut back their subsidies on oil. The overall low demand and high supply of oil caused drop in the oil prices from USD 115 per barrel in June 2014 to USD 80 per barrel in November.

Now comes OPEC that has a cluster of oil-producing countries that pump almost 40% of the world’s oil. In past, this lobby had made several attempts to influence the oil pricing to rise or fall through strong coordination to either cut back or increase the production of oil. On 27th of November 2014, 166th Meeting of OPEC took place in Vienna in which a heated debate took place among the OPEC members regarding fall in the oil prices. Some countries like Iran and Venezuela wanted the cartel to cutback the oil production so that the prices of oil increase. They specially wanted Saudi Arabia to cut back its oil production. The countries who were in favor of production to be cut back actually needed to have high oil prices to meet break-even point on budgets and pay off the government spending that have been piled up.

On the other hand, Saudi Arabia was in the opposing side of the house and they were against the motion. Saudi Arabia wanted to retain the oil production and was in favor of oil prices to be dropped. The reason for this was the event of 1980 when the oil prices were falling and countries cut back their oil productions to boost oil prices. The result was that the oil prices still kept declining and Saudi Arabia lost its market share. According to Saudi Arabia they can live with the falling oil prices as they believe that it is temporary and short lived. The Saudi government has already built up a huge foreign exchange reserve in order to finance the deficit.

In the end, the debate ended with the conclusion that there will be no change in the oil production and Secretary General of OPEC, Abdalla El-Badri declared that the oil will be produced at 30 million barrels per day. This caused the oil prices to drop further and the price went down from USD 80 per barrel to USD 70 per barrel, and reached below USD 60 a barrel by mid of December 2014. In the ongoing situation Mauldin predicts that as United States is a wildcard player so they will be able to get profits even at USD 40 per barrel due to its lower production and innovation in technology. However according to him even if now the oil price rises to USD 60 per barrel, Saudi Arabia would not be able to stand where it used to be in the good old days.  The situation is alarming as recently on 4th April 2015, the oil prices have dropped down below USD 36 per barrel.  

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