The current supply chain of oil is very fragile with 16.4% of current global production at risk of disruption due to turmoil in major oil producing countries.
What are the risks these countries are facing today, and why oil production risks are much higher today than any time in the past several years?
How sensitive is crude price to oversupply or undersupply and what will be the impact of such disruptions on the price of crude?
As promised, I am submitting this article today as the 2nd part of a recent report I published on Seeking Alpha where I argued why Crude Oil (NYSEARCA:OIL) prices are likely to head much higher in the near future to levels predicted by Major Banks and Analysts being $40-$50 a barrel, a price range also confirmed recently by the Energy Information and Administration (NYSEMKT:EIA), a top watchdog. I gave several reasons to justify my arguments including why oil supply/demand balance will be reached in 2016 and why the effect of new Iranian oil to the global supply market will be immaterial. To access Part 1 of my report, you can check the following link:
In this article, I will argue why 16.4% of the global oil production is at risk, and why crude oil may jump to over $100 again soon, levels seen several times in the recent past years in 2007, 2008, 2011, 2012, 2013 and 2014.
Turmoil in Oil Producing Countries
So far, the turmoil in nations supplying crude has not affected the supply flow of oil. On the contrary, the current chaos has even contributed to oil prices going down due to countries like Russia and Saudi Arabia pumping at record levels to maximize short-term gains, and in the case of Saudi Arabia, to put US shale-oil producers out of business and hinder any increased production by its arch-rival Iran. Furthermore, many of the politically and economically less stable countries such as Venezuela and Nigeria were able to survive, although barely, the current rout in Crude Oil. But imagine if things change: One or more major producing countries fall into total chaos and start collapsing. Imagine if countries holding 16.4% of global oil production, fragile to begin with due to their internal and external political structure, start facing extreme turmoil due to current low oil prices that could result in major disruptions in the chain of global supply. What will be the result on oil prices and how high can they go?
In order to address the above question, we have to look at several factors:
- How sensitive is crude price to oversupply or undersupply?
- Which major oil producing countries pose the greatest risk to the chain of global oil supply?
- What are the risks these countries are facing today, and why oil production risks are much higher today than any time in the past several years?
- Finally we have to assess the impact of such disruptions on the price of crude.
Crude Oil Prices are Extremely Sensitive to slight levels of oversupply
In order to assess the level of oversupply in Crude Oil —how much oversupply and for how long-that resulted in the price crashing from $98 on December 31, 2013 and reaching a price of $36.6 on December 31 2015, a 63% decline in price. I compiled data published by the EIA over 2 years in order to assess the level of oversupply during this 2 year period.
According to the EIA, crude demand supply and demand during 2013 was mostly balanced with demand exceeding supply by 0.1% on average. During 2014 and 2015, the balance shifted resulting in a 2 years of overproduction. What is striking in the table above is that a very small oversupply in crude oil during the years 2014 and 2015 led to a phenomenal decrease in the commodity’s price. In 2014 an average oversupply of 0.9% resulted in a plunge in crude prices by 46%, while in 2015 an average oversupply of 2.1%resulted in crude prices further plunging by 32%, to reach an overall decline of 63% during the 2 year period:
Therefore we can conclude that oil prices are extremely sensitive to slight changes in supply levels, and a very small volume of oversupply can lead to a massive movement in crude oil prices, and by the same token, we can argue that a slight volume of undersupply in the commodity can lead to a massive increase in the price of crude.
Major Crude Suppliers Nations that are considered “high risk” to the global supply chain
The current level of oil price is not only artificially low but irrational. In formulating their budgets, major oil producing nations have based their spending plans on an assumed crude price going from $50 a barrel, to break-even in their budgets, to as high as $200, with the average being over $70. Theses break-even levels do not make sense based on the current Crude price of around $30. Let us look at the oil Break-Even Price by country, being the price needed for these countries to balance their budgets:
Source: theguardian based on data from IMF, EIU, and Bloomberg
The disconnect between the current oil price and the spending budget is presenting fiscal crises in several countries, some of which include the world’s most pivotal economies. This has prompted David Goldwyn, former State Department coordinator for international energy affairs in the first Obama administration, to state recently that “budgets are underwater, and some quite dramatically. It’s increasing the fiscal deficit and requiring countries that were already facing low growth to suffer even higher pressures. Current oil prices raise a red flag for political tensions and civil unrest throughout the oil-producing world”. He added that “”Several of oil dependent countries — such as Iran, Yemen, Libya, Venezuela and Nigeria — are fragile to begin with shorting them money, and that’s where you have to watch the stability issues.”
The collapse of a domestic economy starts with high levels of unemployment and extreme poverty, food and basic supply shortages, people queuing overnight for necessities such as soap, milk and diapers, ending up with violence on the street, state of emergency, currency devaluation, and political unrest that can topple governments.
According to Mr. David Goldwyn, countries at risk of collapse include Libya, Venezuela and Nigeria. In addition to the above 3 countries, I will argue that Algeria and Saudi Arabia are also at risk of collapse, and all 5 nations together put at risk 16.4% of global oil supply. I have excluded in my analysis Yemen because its oil production is not material, and Iran because of its more stable economic outlook.
The following table depicts all the major oil producing nations and how much they contribute to the total global supply of crude:
The countries in my opinion which are running a short-term or intermediate risk of collapse are highlighted in color Red being Venezuela, Nigeria, Algeria, and Libya who together add up to 16.5% of Global oil production
Venezuela: Venezuela, the world’s 9th largest oil producer (2% of global production) and the 10th largest exporter, relies on crude sales for roughly96% of its exports, and more than half of the country’s GDP. As a result, Venezuela is acutely exposed to any dip in oil prices, and highly vulnerable to fluctuations in oil prices. Venezuela’s exports to the U.S. peaked at $48 billion in 2008, according to the IMF. That number has declined dramatically since then, sinking to just $26 million in 2014, and there is evidence that the country has become in 2016 a net importer of oil from the US because its oil is very heavy in nature and expensive to refine and export, given the current low oil prices. During the prolonged oil bonanza that lasted until 2014, Venezuela’s economic mismanagement was masked by its soaring oil revenues, which were used to finance populist social programs. However, the oil-dependent economy, without a competitive non-oil sector, is already facing an economic crisis. Bloomberg reported recently that inflation will surge to 720 percent in 2016 from 275 percent last year.
Venezuela has hit “Point of No Return” with 2016 bankruptcy as “difficult to avoid” according To Barclays Bank, stating that “the economic emergency decree and any measures that the government could take at this point may be too late. After two years of inaction and the recent decline in oil prices, a credit event in 2016 is becoming increasingly difficult to avoid”. With evidence that crude exports of Venezuela already starting to dwindle, more turmoil resulting in further cuts is bound to have a devastating effect on the global crude supply. Venezuela oil exports in 2014 accounted for 3.7% of global oil exports.
Nigeria: Nigeria is the world’s 10th largest oil producer (2.0 % of global production) and the 6th largest exporter. Like Venezuela, Nigeria gets nearly all of its exports and foreign exchange earnings from petroleum, with about 70% of the federal revenue coming from crude oil sales. This oil-rich nation has suffered from dysfunctional governance for decades, and now tensions between the Christian South and the Muslim North are rising, while the Boko Haram group, with sworn allegiance to ISIS, is fighting to overthrow the government and create an Islamic state. Boko Haram is causing havoc through a wave of bombings, assassinations and abductions increasing oil supply disruptions, and resulting in over 3 million refugees and displaced people. Furthermore, the latest contested general elections raised fears of a military coup, and resulted in Standard and Poor’s credit rating agency downgrading Nigeria outlook and debt rating in 2015. Due to heavy debts and reduced revenues, the government in 2016 is expected to end fuel subsidies, increase taxation and reduce its workforce as it may have no money to pay salaries. The local currency is expected to fall by a further 20% in 2016. Nigeria is a country in crisis to say the least, and the deteriorating security has caused recently divestments from international oil companies including Petrobras, Shell and Chevron adding to the fragility of Nigeria’s oil sector.
Libya: Libya which currently produces 0.4% of global oil output is also among multiple countries facing economic troubles and political turmoil amid plunging oil prices. Libya is a member of the Organization of the Petroleum Exporting Countries, the holder of Africa’s largest proved crude oil reserves, and the fifth-largest holder of Africa’s proved natural gas reserves. Its economy depends primarily on the oil sector, which represents over 95% of export earnings. Moreover, the oil and gas sector accounts for about 60% of total GDP. Rivalries between various armed groups present a serious threat, as fighting continues over Libya’s diminishing wealth resulting in continuous disruptions in the oil production. According to a recent report by the EIA (November 2015), the country’s oil sector was crippled in mid-2013 as widespread protests led to a sharp deterioration of the security environment and the closure of loading ports, oil fields, and pipelines. Currently its eastern parts are experiencing oil supply disruptions due to armed militias’ blockading oil pipelines and export terminals. Relatively little oil infrastructure has been damaged despite several Isis attacks, and ongoing militia fighting, but this may not stay that way for a long while.
Algeria: Algeria’s oil production represents 1.1% of global output, and accounts for 60% of the state budget. Algeria is estimated to hold the third-largest amount of shale gas resources in the world, according to a U.S. Energy Information Administration (EIA) sponsored study. Even before the collapse of oil prices, the country has a history of recent political turmoil and violence. The Arab uprisings were one of the catalysts of political ‘awakening’ after years of government corruption and mismanagement. Tens of billions of dollars havebeen wasted in overpriced, badly built, infrastructure projects. Funds have been embezzled and moved abroad or lavished on state subsidies – estimated at a staggering 29% of gross domestic product (NYSE:GDP) – for oil, gas and food. Protests against social frustration and high unemployment broke out as early as 2011, and grew in intensity in 2013 when a militant attack on gas facilities prompted security concerns about operating in Algeria’s remote areas, particularly in the south. This fragile social context became an incubator for security risks. The region, to which Algeria belongs, harbors a number of dangerous militant and criminal groups, including the terrorist group ISIS, who has taken advantage of the Arab Spring, political and social conflicts to accelerate their operations, and expand their influence. Algeria’s over-exposure to the oil commodity, will force it, in the face of collapsing oil-related revenues, to put in place severe spending restrictions that will likely worsen social discontent and increase its economic turmoil.
Gross natural gas and crude oil production have gradually declined in recent years, mainly because new production and infrastructure projects have repeatedly been delayed due to the unstable environment. Any major disruption to Algeria’s hydrocarbon production would not only be detrimental to the local economy but, depending on the scale of lost production, could affect world oil prices. Also, because Algeria is the second-largest natural gas supplier to Europe, unplanned cuts to natural gas output could affect some European countries.
Saudi Arabia: The largest world oil exporter (10% of global production and 19% of total global crude exports) is also not spared. Saudi Arabia has led the ramp up in production as it seeks to dominate market share and crowd out rivals in the US, but the IEA noted that the Saudis’ spare production buffer was now “stretched thin“. Furthermore, this oil producer can no longer increase the quantity of oil sales abroad because of the need to meet rising domestic energy demand due to a fast growing population (reported by a study from Brown and Foucher). From 2005 to 2015, Saudi net exports have experienced an annual decline rate of 1.4 percent. A report by Citigrouprecently predicted that net exports would plummet to zero in the next 15 years.
- Economic instabilities: Even with Saudi Arabia’s large foreign exchange reserves and broader borrowing abilities, it can only endure the economic strain in the short term. The country is facing a record annual deficit of close to $100 billion (largest in its history). With Saudi Arabia currently running a yearly deficit of $100 billion, they will burn through their estimated $550 billion of reserves in less than 5 years, which has prompted the International Monetary Fund (NYSE:IMF) to warn that Saudi Arabia could be bankrupt by 2020. The collapse in oil prices and commodities are making the riyal-to-U.S. dollar peg increasingly unsustainable, while fueling the risk of a stock market crash in 2016. Its government undertook recently a series of unpopular measures to battle the deficit, including unprecedented cuts to public subsidies on fuel, power, food and water. The price of gasoline, for example, will be increased with an immediate effect by more than 50%. Subsidy cuts in food requirements, 80% of which are purchased through heavily subsidized imports are likely to have a deep effect on the country’s dissidents. The grumble of a highly discontent population is not far away, possibly leading to the resurgence of extremism calling for the topple of the ruling monarchy.
- Geo-Political instability: Saudi Arabia’s economical instabilities aside, the Kingdom’s external and internal political environment is pointing to several stress and instabilities. While Iraq, Syria, Yemen and Egypt are all experiencing civil unrest and all-out war, which can be traced back to the devastating impact of declining state power. Historically, Saudi Arabia has been conservative and careful not to get involved directly in the regional conflicts, and in several instances acted as the peacekeeper in the region trying to diffuse volatile tensions; however in the past few years, there has been a clear shift away from its historical prudent policy. The Saudi government recently supported the Egyptian army’s seizure of power, is directly involved in the military intervention in Yemen, and supporting the hardline opposition in Syria and Iraq. They have also been working with the Pakistani military to strengthen the Pakistani army in order to counter Iranian influence in the region. To aggravate matters, signs of internal turmoil are starting to appear after the government’s crackdown on its main political opponents at home. Saudi Arabia shift in political policies and direct involvement in conflicts will no doubt significantly increase the risk of wars overreaching traditional hotspots, and can easily inflame to include regions where major crude oil is being produced or transported. “The Political turmoil inside Saudi Arabia is an early warning sign that the Middle East conflict is not just being fought out in the spaces between the oil fields, and that the instability of the war will have an impact on the situation inside the great oil producers”, as reported by the-american-interest.com.
The collapse of Saudi Arabia is inevitable should the monarchy decides not to change course soon enough by starting to manage world crude supplies again, like it used to, and by carefully managing and moderating its regional political stance.
Effect of the Collapse of Country Producers
The current chain of crude supply is very fragile. If crude prices do not adjust significantly to the upside to over $50 a barrel being the minimum break-even point for most of these nation oil producers, forced disruptions in the supply chain through the collapse of a single or several country producers is imminent. Although the current low oil prices did not significantly impact the supply flow of oil yet, imagine that Venezuela falls into total chaos putting at risk 2.5% of global oil supply coming from there. Also imagine if Nigeria collapses and another 2% of global oil supply experiences disruptions. Or even worse imagine if Saudi Arabia’s current aggressive political strategies lead to a full-fledged war in the Middle East resulting in pipelines getting blown up or war stopping production in key oilfields. Should added turmoil hit any of the above 5 countries, the chain of supply can be quickly disrupted with consequences on the resulting imbalance in supply felt worldwide. While 16.4% of globally supply is at risk, what would happen to oil prices if a sudden 3% or 5% of global oil supply gets cut? We have seen at the beginning that oil prices are extremely sensitive to slight variations of oversupply and an average 1.5% oversupply in oil over a period of 2 years resulted in 63% price plunge in the commodity. When this occurs, crude can easily overreact and spike back up to over $100 a barrel as it did several times in the recent past years in 2007, 2008, 2011, 2012, 2013 and 2014, when the world experienced fundamental supply shortages and turmoil in many oil producing countries:
- 2008: This year was when crude oil peaked at an all time high of $145 a barrel following several events: In February 2008 Venezuela cut off oil sales to ExxonMobil during a legal battle over nationalization of the company’s properties. Production from Iraqi oil fields had still not recovered from wartime damage, and in late March saboteurs blew up the two main oil export pipelines in the south-cutting about 300,000 barrels per day from Iraqi exports. In May 2008 about 1.36 million barrels per day of Nigerian production was shut due to a combination of militant attacks on oil facilities, sabotage, and labor strike.
- 2011: Political turmoil in Egypt, Libya, Yemen, and Bahrain drove oil prices to $95/barrel in late February 2011. In April 2011 a significant drop in Libyan production and fears of more instability in the Middle East pushed the price of oil over $112 a barrel.
- 2012: Concerns over shortages of oil after Iran, following sanctions, threatened to close the Strait of Hormuz, through which one-fifth of exported oil travels, resulting in the price of oil to stay near $100 throughout January, and reached over $107 in February. This is following a global dispute over Iran’s nuclear policies.
- 2013: In July 2013 oil prices were the highest in more than a year as a result of supply disruptions in Libya, Iraq and Nigeria, and trouble due to the Egypt uprising. Brent crude had climbed $108.5.
- 2014: During March 2014, due to the dispute over Crimea, problems in Libya, and the Houston Ship Channel collision, WTI crude rose above $100, then in June 2014 reached higher to over $106 following further trouble in Iraq and the Middle East.
The Role of Speculation
The story of oil price overreaction and subsequent collapse is not driven solely by fundamentals, as the role of speculators cannot be underestimated. The speed and magnitude of the price surge and collapse is the result of high speculative price movements that are popped. Most oil spikes and collapses since the spike of 2007-2008 were magnified by the actions of investors who bought oil not as a commodity to use but as a financial asset. The same applies today as the commodity is highly shorted, and the price of oil is severely oversold. Any shock to the crude supply system will result in extreme price movement as short positions have to be covered, and new long positions added.
The current low price of oil comes at a heavy cost to major oil producer nations. It is only a matter of time until one or more of the oil producing nations fall apart, causing severe interruptions in the crude oil chain of supply. On a final note, I would like to quote a fellow Energy expert at zerohedge.com“for all those who are praying for an oil bounce, your day may be near, because nothing will send the price of crude soaring quite as fast as one entire OPEC nation suddenly entering a death spiral of chaos.”
This article was brought to you by Rida Morwa, Energy & Commodities expert, and editor of Retire with High Dividends newsletter, a premium service by Seeking Alpha.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.