Valdai Club

Large and rapid changes in the price of crude oil have correlated with major geopolitical and economic crises globally.

As oil price continue to fall with Brent trading below $40 per barrel, concerns are growing that energy exporting countries may face disastrous economic and political consequences. In an interview with valdaiclub.com, Gürkan Kumbaroğlu, Professor of Industrial Engineering at Boğaziçi University in Istanbul, Turkey, explained the economic reasons behind the current slump and its political implications.

Mr. Kumbaroğlu, what are the reasons behind the current fall in oil prices?

Oil prices are determined primarily by supply, demand, reserves and market sentiment toward oil futures contracts. This a question with various social and geopolitical aspects involved, but the answer boils down to the simple economics of supply and demand. The United States domestic production has nearly doubled over the past six years meeting the needs of the world’s largest consuming country and reducing its import needs. The United States imported 7.3 million barrels per day of crude oil in 2014, down from 10 million barrel in 2007. Imports from Saudi Arabia, Nigeria and Algeria have suffered from drastic cuts and have to find new markets. They need to keep prices low so as to compete with rival suppliers amid sluggish demand. Saudi Arabia, the world’s largest crude exporter, has been offering its oil at significant discounts making it more attractive than others.

And the prospect for increased supply is bright. Canadian and Iraqi oil production and exports are rising year after year. Iranian crude is about to enter the markets again after the disembargo. Moreover, the United States has become a major exporter of refinery products. Exports of oil products were 4.2 million barrels per day in 2014, up from1.4 million barrels per day in 2007. The United States has actually gone from the largest importer of refined petroleum to the largest exporter over the past decade.

Prospects for US crude exports are there now as well, since Congress lifted the 40-year ban on oil exports. Whenever the oil price recovers, US production will rebound and American crude will become another supply source in the global marketplace. On the demand side, on the other hand, there is not much traction as European economies are in weak growth similar to developing countries. Moreover, technology is advancing and vehicles are becoming more energy-efficient. As a result, there is a significant oversupply of crude oil, which naturally leads to lower prices as economic theory dictates.

Which countries benefit from cheap oil? Can it help diversify sources of energy for the consuming countries?

The plummeting price of oil has key economic benefits for countries, which heavily depend on oil imports like India, China, Greece, Germany and Turkey. In these countries, cheap oil won’t help to diversify sources of energy but it should increase overall economic activity as the cost of production decreases for industries, especially for those production activities that are heavily dependent on oil inputs. This should boost both investment and employment. Lowered prices should cause inflation to drop and increase spending. All of this should boost GDP in these countries.

Can cheap oil lead to lowering of life standards in the producing states and social unrest?

Cheap oil surely leads to lowering of life standards in the producing states and can lead to social unrest. Large and rapid changes in the price of crude oil have correlated with major geopolitical and economic crises globally. Oil-producing countries like Venezuela, Nigeria, Ecuador, Brazil and Russia are suffering economically from low oil prices. Let’s take the example of Saudi Arabia. With income from oil accounting for about 80 percent of revenue, Saudi Arabia’s budget surplus has turned into a serious deficit reaching 20% of gross domestic product. If the Saudis do not adjust spending or find other sources of revenue, under the current standing of low oil prices the world’s richest nation on the per capita basis runs a risk of going bankrupt within the next five years. Of course, such a risk may create social unrest.

It’s also a problem for smaller economies, such as Uzbekistan and Turkmenistan, whose fragile foreign currency exchange and capital policies leave them vulnerable to low oil prices. Oil producing countries all face economic challenges based on weaker incomes and likely spending cuts.

What is the potential impact of cheap oil on alternative energy projects across the world?

I do not think that low oil prices will have a significant impact on the diffusion of renewable power generation projects like wind and solar as oil is not a direct substitute. It is very rare that oil is used for power generation. However, I believe that alternative energy projects for transportation like electric and hybrid vehicles will get delayed. The advanced battery industry and other companies working on technologies relating to light vehicle electric drive may suffer from low oil prices.

However, alternative energy projects have benefited from significant technological improvement over the last decade when oil prices were high, which brought technological improvement and made them more competitive economically. I don’t think that these projects will get derailed but it is likely that some of them which would be substitutes for oil get delayed.

What can be done to minimize the potential geopolitical risks?

Oil is a strategic commodity and history is full of armed conflicts in regions that contain oil reserves. Also strategic locations where it is advantageous to develop production or transportation infrastructure for oil products have served as a marketplace for armed conflicts. No matter what price, there has always been a geopolitical risk in strategic oil locations. To minimize the price impact related risk, I think that better dialogue and cooperation between oil producing and consuming countries is needed. Based on good dialogue, even a joint hedge fund could be established to protect oil producing countries at times of low oil prices and oil consuming countries at times of high prices.