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6/1/2015

Last Resort: How Volatile Nations Addicted To High Oil Prices Could Stop Oil's Plunge oilpro.com

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Last Resort: How Volatile Nations Addicted To


High Oil Prices Could Stop Oil's Plunge
12 min read original

The recent plunge in oil prices has sent shockwaves across the global
economic and political order. If oil prices remain low, some volatile, oilexporting countries will be driven to the brink of financial collapse. As long
as oil prices fall, these countries will be forced to scale back social and
defense spending. The socioeconomic outlook for some very dangerous
nations has entered a destabilization spiral directly because of lower oil
prices. The destabilization of volatile nations increases the risk of a supply
disruption, which could cause a spike in oil prices.

Shunned, Cornered Nations Will Act To Protect Their


Interests
Many of the countries now on the verge of economic crisis because of the oil
collapse lobbied Saudi oil ministers to cut output and protect high prices in
Novemberto no avail. Over the past two decades, Saudi has been a bastion
of stability in the oil markets, keeping the peace by supporting high oil
prices.
In their move to protect market share rather than price late last year, the
Saudis effectively shunned some very dangerous nations that thrive when
oil prices are high. With Saudi's support gone, it is possible that these
nations will step up and try to drive oil prices higher on their own. It is
possible that these new supportive actions will not be as peaceful as Saudi's
tactics in years past.

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These nations have not yet resorted to unilateral action to push oil prices
higher, but they do have options at their disposal, and they are on the verge
of financial crisis. In these nations, financial crises mean social uprising,
political upheaval, and loss of military control. None of these outcomes are
appealing to the incumbent leaders that often wield immense unilateral
control over their nation's defense infrastructure and foreign policy. It may
be only a matter of time until some country with their back against the wall
pulls the trigger on aggressive action to push oil prices higher.
In our view, Saudi can only push oil prices down so far and for so long before
a supply disruption will send prices back up again (perhaps temporarily, but
up none-the-less). In this post, we try to answer three important questions:
i) what dangerous nations could act out on their own to support oil prices,
ii) how long will these volatile countries take the pain of lower oil prices,
and ii) what might they do to cause oil prices to rally?

The Budgets Of Volatile Countries Depend On Oil Prices


Well Above Current Levels
"Continued price declines would for some countries and companies make
an already difficult situation even worse...The resulting downward price
pressure would raise the risk of social instability or financial difficulties if
producers found it difficult to pay back debt," the International Energy
Agency said in its most recent oil market report.
Oil Prices Required To Balance Country Budgets

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Countries heavily dependent on oil revenues are at risk of political and


social instability; Breakeven prices; Source: CNBC
Several volatile countries suffering from low oil prices are the same
countries that have previously indicated willingness to take aggressive
(including military) actions when they feel backed into a corner- Russia,
Iran and Venezuela are key examples. There are several hypothetical
scenarios involving such nations that, if played out, could immediately drive
the oil price higher.

Russia
Socio-Economic Crisis Background
In Russia, energy export revenue represents more than half of the
government's budget. The strong public support President Vladimir Putin
previously held due to the improved economic performance of the nation
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during his tenure has been thrown into doubt on the collapse of the ruble in
late December, which threw the country into financial panic. The Russian
central bank estimates that GDP could drop by 5% in 2015. Further, inflation
is at 10% but is expected to accelerate quickly.

O&G revenue represents more than half of the Russian federal budget and
two-thirds of its export revenue (approximately 300 billion annually). The
IEA estimates that 68% of Russia's foreign currency earnings are sourced
from the oil-export business, and about half of its annual budget is
underwritten by the industry. Granted, western sanctions imposed earlier
this year on the oil and gas sector have harmed the country's economy, but
in recent weeks it has been concern over the nation's corporate sector,
especially the fact that Russian companies must repay $100 billion-worth of
foreign debt in 2015, that has fostered most of the turmoil.
Actions Russia Could Take To Send Oil Prices Higher
With a breakeven price of $102/barrel, all of this provides the rationale for
Russia's need for oil prices to rise. If the situation continues to deteriorate,
further military incursions into Crimea and the related coordinated
manipulation of the provision of energy to Europe, could impact supply,
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driving prices northward. Russia might also increase their support for
dangerous MENA factions, potentially pushing these nations towards a
conflict that would cause oil prices to spike. And that sort of spike is
precisely what Russia needs right now.

Iran
Social-Economic Crisis Background
Months of declining oil prices and uncertainty whether the country will
secure a nuclear deal rescinding international sanctions has caused the
weakening of Iran's rial, which has lost about 8% of its value since late
November. And Iran has been hit so hard by falling oil prices that its
government is now offering young men the choice of buying their way out of
an obligatory two years of military service, the New York Times recently
reported. Existing sanctions on Iran are already withholding roughly 1
M/bd of Iranian oil off the market, according to the IMF. Thus, with Iran
already exporting less oil now than it did prior to the sanctions regime,
falling prices have further curtailed the country's economic outlook.
Almost Half Iran's Government Revenue Comes From Oil

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Oil revenue's contribution to government coffers


Some have speculated that the oil price drop is the consequence of
deliberate collusion by the US and Saudi Arabia to punish Iran and Russia
for supporting the Assad regime in Syria. If Iran believes this to be true, it
could steel their will to respond in kind - economic warfare is the territorial
warfare of the prior century. Iran needs oil prices well north of $100 per
barrel to balance its budget, especially since Western sanctions have made
it much harder to export crude.
If oil prices keep falling, the Iranian government may need to make up
revenues elsewhere. Iran is projected to lose approximately $8 billion in oil
revenue from June to the end of this Iranian year (March 31), the Tasnim
news agency reported on December 16. Oil revenues will make up just 33% of
the proposed budget for the next Iranian calendar year, while it was 50% the
previous year.
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Actions Iran Could Take To Send Oil Prices Higher


One of the actions Iran could take in desperation would be to attack the
Strait of Hormuz, which is one of the most important oil chokepoints in the
world. Leading out of the Persian Gulf and located between Oman and Iran,
30% of all the world's seaborne-traded oil (or roughly 17 M/bd), traveled
through the Strait of Hormuz in 2013. An attack on Hormuz would
undoubtedly send prices higher effective immediately.

Venezuela
Social-Economic Crisis Background
The holder of the world's largest estimated oil reserves, Venezuela received
95% of its export earnings from petroleum before prices fell. The country is
now experiencing difficulty in funding domestic projects and a foreign
policy founded in what the New York Times recently dubbed "oil-financed
largess," including shipments of discounted petroleum to Cuba and
elsewhere. President Nicolas Maduro has said the country will continue to
pay down its debts amid concerns on bank markets that Venezuela might
default on its loans. However, inflation at present is north of 60%, and there
are shortages of many basic goods, and many experts say the economy is in
recession.

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Oil Reserves measured in $bln


Like Saudi, vast oil reserves represent half of the government's revenues,
comprise 27% of the country's GDP, and make up 96% of the country's export
earnings. This revenue is thus indispensable in subsidizing socialistic
social programs that are currently at risk if oil prices stay depressed. Earlier
this year, the government allowed the bolivar to drop sharply in the hopes of
eliciting the foreign currency required to import food, medicine and other
imports. Unlike Saudi, Venezuela holds only a small cushion of foreign
reserves to help ameliorate the impact of the recent losses in oil revenue.
With the price of Venezuela's market basket of crude and petroleum
products hovering around $60/barrel as of December 12, many analysts
estimate that the government needs a $125/barrel price to avoid scaling
back or delaying spending commitments.

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President Nicholas Maduro hopes that China will come to Venezuela's


rescue. Goods from the Asian giant are already flooding the country's
market, due to the fact that Chinese credits are linked to the import of
services and products. Consequently, the low-priced imports are hurting
local companies. With state-run PDVSA's debt up more than 10-fold over the
past seven years (to $40 billion), the company's ability to invest in oil
projects has been severely curtailed. And even though the country holds one
of the largest amount of reserves in the world, actual production continues
to decline. In response, PDVSA has cut exports to the US so it has enough to
send to the Chinese. China's imports of Venezuela oil and products have
soared in recent years- from 50 K/bd in 2006 to 540 K/bd at the present
time.
Actions Venezuela Could Take To Send Oil Prices Higher
So what could Venezuela do to send the oil price northward? Recall the twomonth PDVSA worker strike from December 2002-February 2003 that
resulted in the dismissal of over 17,000 employees of the company. During
this time prior to the production boom that would start in earnest about 5
years later, prices were already low, hovering around $30/barrel. Rapidly
recovering oil prices, and the Venezuelan government's seizure of control of
PDVSA in March 2013, alleviated the pain caused by the strike.
However, in today's bearish climate, and with the aforementioned
predicament in which Venezuela is situated, if social unrest affects the
country's largest employer and leads to another strike, the consequent
supply disruption could drive prices northward. And we would not be
surprised if Venezuela took even more aggressive action, perhaps allying
with Iran and Russia to pull some strings and create a MENA conflict that
would spike oil prices.

Libya
Social-Economic Crisis Background
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Libya has had two parallel governments since August when the Fajr Libya
forces captured Tripoli, evicting the internationally recognized
administration out of the capital. Several tanks caught fire at the Es Sider
oil terminal (the country's largest) on December 25 due to rocket attacks
launched by the Fajr Libya from speed boats as part of a failed attempt to
seize control of the country's main oil terminals.

Thick black smoke rises out of a storage tank at Es Sider oil facility; Source:
Telegraph
On Monday, December 29, Brent rose to $60/barrel amid concerns about a
supply disruption in Libya, as the north African country struggles with
protests and port blockades that have reduced output from the 1.6 M/bd
levels seen prior to the 2011 ouster of Muammar Qaddafi. WTI futures
traded at $55.50/barrel on Dec. 29, up $0.76 from the previous session. Since
a new wave of fighting between government forces and the Fajr Libya forces
erupted in mid-December, Libya has witnessed a fall in oil production to
almost 350,000 bpd from the previous 800,000 bpd.

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Libya Violence Runs Risk Of More Significantly Driving Prices Higher


But global oversupply, coupled with OPEC's failure to cut its output quota,
have maintained the mid- and longer-term prospects for a bearish global oil
market. In the short-term, "The disruption in Libya may contribute to
Brent's stabilization," Tom Finlon, the director of Energy Analytics Group,
told Bloomberg.
If this violence and the concurrent attacks on Libya's oil infrastructure
intensifies, the resulting supply disruption could more significantly drive
prices northward.

Iraq
Social-Economic Crisis Background
Officials of OPEC's second-largest producer said December 24 that OPEC
will need to "step in" amid additional declines in oil prices, which are fair at
roughly $70 to $80 per barrel. Iraqi Oil Minister Adel Abdul Mahdi told
Bloomberg on December 25 that "If prices keep falling to very low levels
where the whole equation is not balanced, then definitely OPEC has to step
in." Earlier that week, Iraq's government approved a budget based on $60
oil. With a fiscal breakeven cost of $111 per barrel, according to Citigroup,
together with ongoing ISIS violence in the country's north, Iraq is in a
precarious position.

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Iraqs largest oil refinery is the Baiji facility, located about 50 miles north of
Tikrit
So far, ISIS attacks have been mostly limited to Iraq's northern region. In
terms of oil infrastructure, so-called "mobile refineries" have been targeted.
But because Iraq's major oilfields are located in the south, production has
thus far not been impacted. If ISIS were to move south, significant supply
disruptions could result, thus driving prices higher.
Actions Iraq Could Take To Send Oil Prices Higher
A central interest of Iraqi leadership and ISIS leadership is now aligned:
increase oil prices to secure future revenues. Could lower oil prices weaken
Iraq's resolve to fight ISIS? Might they withdraw troops to at least create
the perception in the market place of ISIS's power grab jeopardizing oil

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resources? In our view, this scenario is now a possibility, and it would cause
oil prices to rise as it did this past summer when ISIS first started to make
headlines and threaten oil infrastructure.

Algeria Snapshot
In late December, Algeria's Minister of Energy and Mines Youcef Yousfi
urged OPEC to cut production to raise prices in order to help a number of
member countries from plunging headlong into a crisis. "OPEC should
intervene to correct the imbalances by cutting oil output to push prices up
and defend incomes of the member countries." He also said that Algeria does
not share the opinion of OPEC's primary suppliers (Saudi, UAE, & Kuwait)
who hold that they should not interfere as the market will settle the price
alone.

Algeria's Minister of Energy and Mines Youcef Yousfi


Algeria holds foreign reserves of $200 billion but is bearing the strain of
falling oil prices because oil revenue accounts for 97% of the country's hard
currency and 60% of its budget. The country is already responding by
tightening its belt. In late December, Prime Minister Abdelmalek Sellal

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announced that public sector hiring would be put on hold in 2015. This is
especially significant, given that about 60% of the jobs in the country are
government jobs.

Nigeria Snapshot
Africa's largest economy depends on high oil prices. Oil and natural gas
income represents the Nigerian government's largest source of income,
representing about 80% of the government's total annual revenue and
nearly all its exports, according to Deutsche Bank. With a breakeven price
estimated at $128/barrel, the country requires an oil price about twice the
current level to realize a balanced budget. The naira's 11% loss in value this
has paralleled the fall in oil prices. Adding to Nigeria's difficulties is that two
oil unions went on strike earlier this week precisely in response to the
government's 10% cut in its budget due to depressed oil prices.

Nigeria's Finance Minister Ngozi Okonjo-Iweala

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Late last month, the Nigerian finance ministry lowered the country's
projected economic growth in 2015- from the previous 6.4% estimate to
5.5%. The new budget is based on a $65/barrel price, rather than the
previous assumption of $77.40. Finance Minister Ngozi Okonjo-Iweala
went so far as to encourage Nigerians "to begin thinking of the country [as]
a non-oil country."

History Serves As A Precedent


Several geopolitical upheavals over the past 40 years have prompted global
oil prices to rise in relatively short order. We've chosen three such events as
illustrative of the correlation between supply disruptions and price
increases.

The 1973 Arab Oil Embargo


In 1972, the price of oil was approximately $3.00. By the end of 1974, the price
had quadrupled to $12.00. What drove this drastic price hike?
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On October 5, 1973, Syria and Egypt launched an attack on Israel,


inaugurating the Yom Kippur War. Arab oil exporting countries imposed an
oil embargo on the countries supporting Israel, cutting output by 5 M/bd.

Approximately 1 M/bd was made up via increased production by other


nations. However, the net loss of 4 M/bd extended through March 1974 and
accounted for 7% of production. In response, the oil price spiked 400% in
only six months.
The Iran-Iraq Conflict
The geopolitical instability and market uncertainty caused by the 1978-1979
Iranian Revolution drastically affected oil prices. 2 M/bd to 2.5 M/bd were
lost per day between November 1978 and June 1979, and production nearly
halted. After the revolution, output recovered shortly with up to 4 M/bd
produced.

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But Iraq's invasion of a weakened Iran in September 1980 set in motion a


chain of events so that by November 1980, the two countries were producing
a total of 1 M/bd, or 6.5 M/bd less than the previous year.
Global crude oil production was 10% lower than in 1979. During these years,
oil prices rose from $14 in 1978 to $35 in 1981.
The Persian Gulf War
Concerns over, and then the reality of, Iraq's invasion of Kuwait on
September 2, 1990, sent oil prices northward. The average monthly price of
oil rose from $17 in July to $36 in October.

Source: Fortune
In the buildup to the invasion, Iraq and Kuwait had been producing 4.3
M/bd. This potential loss, jointed to the threats to Saudi Arabian oil
production, yielded a rise in prices from $21/barrel at the end of July to
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$28/barrel on August 6. In the immediate wake of the invasion, prices


increased to a peak of $46/barrel in mid-October.
The intervention of the US and subsequent military success helped to
mitigate the risk to future oil supplies, thus calming the market and leading
to a restoration of stability. After only 9 months, the increase had subsided.

Disturbing The Peace Could Be A Last Resort For Dangerous,


Cornered Nations
As we have observed throughout this post, lower oil prices severely
jeopardize the "lifestyle" many volatile nations have become accustom to in
the past several decades of higher oil prices. The floor has now been pulled
out from under these countries' budgets. Historically, conflicts in MENA,
rising geopolitical tensions, and attacks on oil infrastructure have been
linked to oil price spikes.
If oil prices continue to fall, we can expect to see the sentiments already
expressed by the likes of Algeria, Russia, Iran and Venezuela translated into
action. The disruption of an already-tenuous global geopolitical balance by
one of these nations to cause oil prices (and their revenues) to rise is not out
of the question. With Saudi's peaceful support for oil prices pulled, it is
possible that the "oil price war" could translate into a literal one in the not
too distant future.

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