Lower oil price becomes political and economic necessity

|TAP Special| A lower oil price has now become both an economic and political necessity. This is in view of the complications introduced by the disruption of Middle East politics brought about by  recent advances by the Islamic State in Syria and Iraq.

Bank of America Merrill Lynch notes in a review of the regional political and economic situation that the threat of a radical Islamic Sunni caliphate that extends across Middle East borders has suddenly created an incentive for key regional and global players to cooperate. Lower oil prices could be a major incentive for such closer cooperation.

Old allies including NATO and Australia have already started discussions to form a military coalition to fight the jihadists. The renewed perceived threat from Russia following recent developments in the Ukraine has also rekindled the purpose of the North Atlantic Treaty Organization.

Lower oil prices could weaken Russia’s hand by significantly curtailing revenue streams, just as they did the mid-1980s and again in the late 1990s. A lower oil price would quickly push Russia into a widening public sector deficit and could place additional pressure on Russia to de-escalate the crisis in Ukraine. A Saudi fuelled drop in Brent prices to $85 per barrel could place a significant dent in Russia’s finances in addition to the current global restrictions.

According to Merrill Lynch analysts, a temporary decline in global crude oil prices could bring some additional benefits to Saudi Arabia too. After all, US crude oil production has increased by 3.6 million bpd in the last four years, turning the US into the world’s largest liquids supplier.

With production costs ranging from $50 to $75 at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment. Postponing energy independence would inevitably force the US back to the drawing board in the Middle East.

Some analysts have suggested that the decline in Saudi Aramco’s Official Selling Prices (OSPs) signal a willingness to accept lower prices.

Merrill Lynch believes that the Saudis in fact want prices to drop below $100. Siince 2008, on average, a 10 percent drop in oil prices has historically led to a 1.5 percent reduction in Saudi production 3 months later, rising to 2 percent after 6 months. Hence the recent price drop of over 10% would imply a Saudi supply response of 150-200 thousand b/d within the next 3 months. But this time, Saudi Arabia has increased production by 2 percent since June.