New oil shock

The International Monetary Fund (IMF) highlights the risk of an oil price shock as one of the two key threats to global economic recovery this year, alongside the risk of a euro-zone meltdown.

High oil prices are bad for the global economy. Saudi oil minister Ali Naimi and IMF Managing Director Christine Lagarde have both repeated this warning in recent weeks, saying that the world needs lower oil prices. Such a consensus between producers and consumers is remarkable. But with oil prices already high, and threatening to spike if looming EU and US sanctions on Iranian oil exports disrupt supplies, both sides have cause for concern.

“High oil prices are contributing to the global economic malaise,” says the Organisation for Economic Co-operation and Development’s energy watchdog, the International Energy Agency (IEA), in its latest World Energy Outlook report. “Further price rises could plunge the world economy back into recession.”

An oil supply disruption triggered by sanctions against Iran due to be implemented by July could trigger an oil price spike above the $147 per barrel (bl) record of July 2008 for the price of the European benchmark Brent crude. The IMF’s latest World Economic Outlook (WEO) says that sanctions on Iran already mean that “the potential Iranian supply shock is morphing into an actual shock because lower Iranian oil production and exports seem inevitable during 2012 and beyond.”

In a worst-case scenario that assumes a 50% price increase, the WEO warns that an oil price shock caused by a significant supply disruption could trigger “a major slump reminiscent of the 1930s” and “hurt many emerging and developing economies”.

These developing economies are the oil exporters’ only significant growth markets, as OECD oil demand is on a steady downward trend that was accelerated by the Great Recession. Surging Chinese oil consumption has led growth in global demand since 2005, when oil demand peaked in the US, the world’s largest oil market.

The risk of an oil price spike reversing that emerging market growth explains Saudi Arabia’s call for relatively lower oil prices. Saudi Arabia, OPEC’s linchpin producer and the world’s largest oil exporter, points to its 2.5 million barrels a day (mn b/d) of spare crude capacity to reassure consumers. Riyadh is talking up its self-appointed role as the “central banker of oil”, assuring consumers that it is ready to apply its own form of quantitative easing to the oil market. It increased its production above 10mn b/d for the first time in 30 years last November, and has kept output at around this level since then.

Saudi Arabia now sees $100/bl as the price that should satisfy OPEC producers’ budgetary needs, as well as easing economic pressure on consumers and ensuring adequate oil industry investment in new capacity.

This year, Iranian production has fallen by at least 350,000 b/d as looming sanctions reduce demand for Iran’s crude, while non-OPEC production cuts removed close to 750,000 b/d in the first quarter. But Saudi Arabia and other Middle East OPEC producers appear to be making up the difference. The price of Brent crude has fallen by more than $10/bl to below $110/bl since Saudi Arabia’s stated price concerns fell into line with those of the IEA.

Yet, it is hard to control the impact of sudden changes in supply on the price of oil. The new oil price consensus between consumers and OPEC will quickly come apart if prices fall too far for producers’ comfort. The Arab spring has heightened concerns over social and political stability in non-democratic Middle East states, prompting their governments to push state spending programmes sharply higher and raising their oil export revenue requirements. The IMF estimates that Riyadh needs at least $80–$98/bl to finance its domestic spending for 2010–16.

In the meantime, more oil can only be good news for the global economy. And the IEA’s latest medium-term projections show supply concerns potentially easing, as planned output additions of around 1.3mn b/d should more than meet expected demand growth of 1.1mn b/d.

Richard Child is the editor of Petroleum Argus.