At Large

Oil Economics As a Blood Sport

OPEC meets later this week, unable to agree on measures to stem crude's falling price.

By 11.26.08

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The raising of oil prices in 1973 and the subsequent Arab oil embargo in reaction to the Arab/Israeli War threw the oil market into its first crisis and a worldwide recession. Since then matters have been kept in hand by a willingness generally of OPEC oil producers to adhere to their self-regulated production structure. Now 35 years later the oil cartel that found its manipulative strength during the earlier crisis finds itself seriously divided over a production ceiling to control the price.

The entire issue rests on the fact that the various producers have substantially different requirements for the dollar-denominated income generated by their sales of crude oil. In general terms the key factor is the amount of this hard currency that is needed to balance their respective external accounts.

The Russians have been careful not to announce their break-even figure, but it's broadly conceded to be approximately $70 per barrel. With oil futures regularly at or around $50 per barrel in New York, the Moscow government accountants have had to go back to their computers.

The Russian "boffins" have to justify the extensive claims of PM Vladimir Putin that his government is going ahead with plans to increase defense spending and at the same time add new tax cuts. Russian business experts and the Moscow stock markets themselves have not shown a willingness to accept Putin's economic interpretations.

Russia's fellow anti-American partners, Iran and Venezuela, are in a similar position of facing a massive gap in their external account balance. Venezuela needed to average $91 per barrel for '08 and that goes up to $102.7 in 2010. Iran is better off in '08 at $57.3 per barrel as against $83.3 in the next two years. These figures must be judged against the projections of both the Deutsche Bank and the Chinese National Offshore Oil Corporation, which have warned that the price of oil could fall below $40 per barrel in the beginning of 2009.

Even if the OPEC members can agree this week on a lower production rate in order to put a brake on the falling prices, there is no reason to believe this agreement will hold. In the past those who are now screaming loudest for production controls, such as the Iranians and Venezuelans, were the very same ones who were maneuvering privately on the gray and black market to get around their own positions.

The Nigerians have been quite open about refusing to cut production. Their oil minister announced in no uncertain terms that it was definitely not in his country's budgetary interest to take a chance on reducing their potential for earning foreign capital through oil export reductions. While it might be that the minister doesn't trust the market to equalize in terms of production and price, it is also a possibility he is strictly negotiating, Lagos-style.
 
Interestingly the UAE, Algeria, Qatar, and most likely Libya can balance their external accounts next year if world prices stay modestly below $50 per barrel. The Saudis appear able to break even, and Iraq, still unable to reach its pre-war production goals, effectively has an exemption as it is in the process of economic recovery.

The 1970s oil embargo woke up the world to the inherent power of the oil producers. Today's worldwide recession has now forcefully reminded those same producers that their income is completely vulnerable to the state of the economics of the rest of the world, and that the entire field of raw materials trade is equally affected. It is a lesson in the interrelationship and interdependence of the various players in the global economy, which has long been argued but now is being played out mercilessly.

In spite of the doom and gloom in the oil world, Dubai last week held the debut of, yet again, another super lavish hostelry. Film stars and moguls of all types were jetted in to attend the opening of the Atlantis, partly owned by one Sol Kerzner. Unfortunately for Sol and his Dubai government partners, Citibank has stated (and it should know about such things) that Dubai is the most vulnerable economy in the Gulf. With a debt that reaches above 100% of its GDP, this mini-state still retains its exuberant belief in itself in spite of the realities of the world economy. The answer is to wish them mazel tov, followed by a strongly stated inshallah!

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About the Author
George H. Wittman writes a weekly column on international affairs for The American Spectator online. He was the founding chairman of the National Institute for Public Policy.