The Oil Circle

Jan. 5, 2016 The decline of oil prices has affected many countries, but has begun to show conspicuously in Saudi Arabia.

|January 5, 2016

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By George Friedman

We recently wrote about the crisis of the exporters. Yesterday was a day when we could see the crisis at work. The stock market crashed in China, and fallout continued from the Saudi execution of a top Shiite dissident. It comes in the context of Iran firing missiles near an American aircraft carrier last week, and Russia’s ongoing involvement in the Middle East, including their relationship with the Saudis. All of these seemingly disparate events began to show their connection.

Let’s begin by tracing the sequence. The 2008 financial crisis caused serious economic downturns in the United States and Europe and a decline in foreign imports. The most affected country was China, for whom Europe and the United States were major customers. China’s economy then slowed down as its exports fell. The weakness in the Chinese economy resulted in it importing fewer industrial commodities, and prices fell across the board. Particularly significant was the decline of oil prices in combination with an increase in global supply.

The decline of oil prices has affected many countries, but has begun to show conspicuously in Saudi Arabia. The foundation of Saudi Arabia’s social system is the ability of the state to provide a safety net for various segments of Saudi society. One of the critical sectors in the Sunni-dominated country is the Shiites, clustered in the east and particularly prevalent near key Saudi oil fields. The Saudis are the rivals of Iran, the world’s leading Shiite country, and the Saudis have long been concerned that the Iranians would instigate unrest or even a rising in the east. Unable to dramatically increase financial flows to any groups due to the decline in oil prices, the Saudis chose this moment to execute a major Shiite cleric it found guilty of terrorism. The Saudis executed this cleric, along with Sunnis similarly charged with terrorism, essentially establishing a moral equivalence between jihadist ideology and Shiite Islam.

This led the Iranians to attack the Saudi embassy. The Iranians of course knew that this would inevitably lead to a Saudi response. They also knew that this would particularly trouble the Americans, who still recall the Iranian hostage crisis, a memory that helped fuel resistance to the treaty with Iran over its nuclear program. Interestingly, this came a few days after Iran fired missiles in the vicinity of the USS Harry S. Truman, a U.S. aircraft carrier. This and other comments indicate that the Iranians are less concerned about U.S. sanctions than they had been.

The removal of sanctions had two significant parts from the Iranian point of view. The first was that removing the sanctions meant as much as $100 billion in frozen assets would be released. The second was allowing investment into the Iranian oil industry and allowing Iran access to global markets would improve Iran’s economic health. Both are important but in the long run the opening of the oil markets and investments were more important as they have the potential to yield more that $100 billion and last a lot longer than the money. The agreement caused serious problems in Iran, as it did in the United States. The Rouhani government was prepared to take the heat for the whole package, but the problem is that the value of the package has lessened. What was a seductive possibility at $100 a barrel is much less interesting at $35. It isn’t going to revolutionize the Iranian economy. Causing a political uproar over the money alone may or may not be worth it, but the deal as a whole has lost some of its luster. The Iranians are willing to risk a breakdown, which resulted both in the missiles and in its response to the Saudis. The deal isn’t dead, but the Iranians are not going to shift their behavior excessively to get it given oil prices.

The Russians have also had a hand in the shift in Iran’s stance, having sought to improve their relationship with the Iranians. The Iranians and Russians are both committed to the Assad regime in Syria. But the Russians have gone farther than they ever have since the end of the Cold War, sending some fighter aircraft to Syria to defend the regime against its attackers. The Russians have a strategic interest in Syria but not so great a one that you would expect them to send fighters there. At the same time, it is a useful gesture not only to the region and the United States, but also to the Russian public. It is a gesture that indicates that Russia is once again a great power to be taken seriously.

This is a point that the Russians need to make effectively at home because the foundation of the Russian economy has been severely weakened by the decline in oil prices. The Russian economy remains heavily dependent on exports of Russian energy and the national budget is built around it. With the fall of the price of oil, the ability of the Russian state and economy to function is seriously compromised. Russia had regarded $70 a barrel as the base price needed to maintain the system. It is now almost half that and the Russian economy is under heavy pressure.

There would normally be serious questions about Putin’s stewardship. However, Russia, like many countries, always generates support for national security issues, particularly in the opening phases. It is not clear to me that Putin would have intervened in Syria in this way had the economy not been staggering. But his reasons for intervening were certainly strengthened by economics.

The decline in oil prices has added to tension between the Russians and Saudis. The Russians support Assad, the Saudis are actively working to topple him. But the real issue is the price of oil. Russian Energy Minister Alexander Novak said on Dec. 28 that Saudi Arabia was responsible for destabilizing oil markets by increasing its production. Given the internal situation in Saudi Arabia, the Saudis were not going to worry about what the Russians needed.

Thus, we are in a world unlike the 1970s. Back then, when OPEC was king, production was in the hands of a few countries and they could set the price. Today, however, the largest oil producer is the United States, and it is preparing to enter the export markets, further weakening prices. Today’s 7 percent decline in China market’s drove home the fact that the origin of the problem, the decline of China’s economy, is nowhere near being fixed. It won’t be fixed until Europe picks up steam, the U.S. increases its appetite for imports, and China’s cost of production, which is currently above that of many competitors like Mexico, drops. In other words, it won’t be fixed for a long time and sometimes a market in decline might mean little from the standpoint of the market, and a lot from the standpoint of the world. We started with China’s market crash and ended with it. In between was the global carnage of what I will call the oil circle.