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The Consequences of Opec’s Failure

Organisation of Petroleum Exporting Countries’ (Opec) decision to cut oil production by 2.2 million barrels a day sounded drastic, but obviously failed to impress the market.

Oil prices, which at their peak of about $147 in July were seven-times higher than their 2002 levels, dropped to around $40 and are expected to fall further as the bet is that fewer barrels would be needed to fuel a shrinking global economy.

Higher oil prices would have helped not only oil exporters avoid budget deficits and slower economic growth but could have induced some modicum of inflation for economies like the United States that are fast slipping into deflation, a general and disruptive decline in prices.

Opec in a way has joined the growing list of international groupings like G3, G7 and G22 and institutions like the IMF and World Bank in failing to come up with a solution to rekindle demand and attain price stability and avoid the consequences of an unprecedented global recession.

Had it been that easy, to cut supply in face of declining demand and achieve price stability, economists around the world would have lost their jobs, universities would have shut their economic faculties and trading floors would have been vacated.

It is far more difficult to price anything for that matter, goods or services, than most people think it is. And that is what people at commodities and capital markets do day in and day out, price in the variables not just demand and supply.

It is becoming more and more obvious that no single country or group of countries have the capability of solving the problems of today’s global economy. A lot more coordination is needed among nations to pull the world out of probably the most widespread economic downturn ever and put it back on a path of sustainable growth.

The consequences of lower prices are dire for oil exporting countries. Most will struggle to fund their budgetary expenditures, and almost all will put off or withhold major infrastructure investments which will be tantamount to delaying future growth. Losers will include economies, quite a few in the Middle East itself, where the inflow of oil surpluses had funded a remarkable stint of economic expansion in the last six years or so.

The suffering is unlikely to end quickly enough. Estimates are that demand for oil will shrink this year and the next too. Two years in a row of falling demand for oil would be a first in 30 years. The closest date for an expected uptick in oil demand is April, when winters end in the northern hemisphere and usually more vehicles hit the road, more planes fly and more ships sail. But that uptick may prove to be a blip given few people are buying cars, or travelling for business and tourism and lesser goods are in trade to freight around the globe.

Opec will meet again on January 19 in Kuwait to discuss more cuts. But that is likely to be an exercise in futile as there is a limit to how much members of the group can cut and live. For example, Venezuela requires oil to be at near $100 a barrel to fund its national budget that has been swiftly expanding since 2002. If oil sells, say at $50, Caracas will try to sell twice as much to avoid political turmoil. The United States and Europe may lose millions in jobs and still manage to thrash out the issue within the walls of their parliaments. But rising unemployment could quickly fuel violent conflicts in countries with weak democratic institutions.

Countries that can break even with oil at much cheaper levels, for example the United Arab Emirates which can sustain its budget requirements at around $30, will also see little incentive in cutting production if those cuts do not translate into higher prices.

Oil producers, who mostly sell their production for US dollars, may also face another challenge — a volatile exchange rate environment, as the dollar slides down to become a cheap funding currency and other currencies appreciate against it. Consequently, oil producers will be getting fewer dollars for the same amount of oil they had pumped last year and each dollar would buy fewer goods and services it used to. This would make sustaining domestic economic growth even tougher.

Some may argue that oil exporters can switch to other major currencies, like the euro. But after having invested heavily, both in political and economic terms, in the world’s largest economy it would be interesting to see who takes that step at a time when the United States probably needs their support the most.

· ovais@khaleejtimes.com