A Tale of Two Oil Shocks | Part 2: 2007-12
by ANDREW SCOTT COOPER
01 Jul 2012 11:22
Part 1: 1973-76
When a Saudi oil flood inundated Iran...and the prospect that it could happen again.
Between 2006 and 2008, oil prices steadily rose in the face of declining production and soaring consumer demand. Oil markets tightened to the point where there was virtually no spare capacity left in the event of an interruption to supply. Conditions mirrored those of the early 1970s. But four decades later, it was China and not the United States whose entry into the energy markets upset the fragile balance between supply and demand. World petroleum consumption rocketed after 2004 as living standards and economic growth in the developing world and particularly in China improved.
Chinese oil consumption increased by 870,000 barrels a day between 2005 and 2007 in the run-up to the Beijing Olympics, explained Professor of Economics James Hamilton of the University of California, San Diego. China's thirst for fuel meant consumers in the West had to compete against each other and pay higher prices. He identified other factors that also played a role in tightening world oil markets. During this same period, Saudi oil production decreased by 850,000 barrels a day. Political instability in Nigeria affected that country's output, while the depletion of older oil fields in Mexico and the North Sea contributed to the decline in supply.
After their discussions with Bush, the Saudi royal family agreed, albeit reluctantly, to open the spigots and exceed their OPEC production quota by 250,000 barrels a day. It wasn't nearly enough. Oil prices broke through the $100 ceiling in April 2008, cracked $120 in May, and rocketed to $147 in July. As the world economy deteriorated and the banking sector trembled, the Saudis finally put their foot to the floor and pumped enough cheap crude to break the very pricing structure that had served them so well over the preceding years. By January 2009, thanks to a combination of the Saudi flood and the American financial crisis, oil prices had fallen to $33 a barrel.
Analysts may debate why the Saudis waited so long to act, and also why their initial efforts to ease supply did not initially take hold. What is indisputable is that oil played an important role in causing the October 2008 financial collapse in the first place. "The role that high oil prices played in the summer of 2008 in tipping the global economy into recession should not be underestimated," said Professor Nouriel Roubini of New York University. "Oil above $140 a barrel was the last straw -- coming on top of the housing busts and financial shocks -- for the global economy, as it represented a massive supply shock for the U.S., Europe, Japan, China and other net importers of oil."
Gas prices of $4 a gallon in the summer of 2008 turned what would otherwise have been a mild recession into a severe downturn, agreed James Hamilton. Consumers were already struggling with mortgage and credit card debt. The high price of oil directly impacted the auto industry and housing construction and sales. Detroit found it much harder to sell gas-guzzling SUVs and the ensuing fall in auto sales shaved a half a percentage point from the nation's GDP. The housing sector was hammered too. Hamilton observed that "the biggest initial declines in house prices and increase in [mortgage] delinquencies [were] in areas farthest from the urban core, suggesting an interaction between housing demand and commuting costs."
What goes up must come down. Predictably, the Saudi flood of 2008 hurt the economy of neighboring Iran. At the height of the mid-2000s petro-boom, the Islamic Republic raked in tens of billions of dollars in surplus oil revenues. "Iran's profits from oil rose last year to more than $45 billion from $15 billion, surging at a rate not seen since 1974, when the country's oil revenues tripled," reported the New York Times in 2006. As I noted at the time: "[T]he surge in Iranian oil profits was accompanied by a marked upswing in regional tensions and violence that included a ferocious month-long war fought in Lebanon between Israel and Hezbollah.... The prospect of President Mahmoud Ahmadinejad using his country's oil revenues to speed up Iran's nuclear program, strengthen the Iranian military, and arm Hezbollah in Lebanon, the radical Hamas Islamic group based in Gaza, and pro-Shia militias in Iraq, was anathema to officials in Washington and Riyadh."
In November 2006, a Saudi security consultant with close ties to the royal family issued a warning similar to the admonition delivered last year by Prince Turki al-Faisal. Writing in the Washington Post, Nawaf Obaid explained that King Abdullah "may decide to strangle Iranian funding of the militias through oil policy. If Saudi Arabia boosted production and cut the price of oil in half, the kingdom could still finance its current spending. But it would be devastating to Iran, which is facing economic difficulties even with today's high prices. The result would be to limit Tehran's ability to continue funneling hundreds of millions each year to Shiite militias in Iraq and elsewhere."
The Saudis flooded the market in 2008 for two reasons. First, they wanted to show good faith to the Bush administration and help the struggling economies of their major trading and investment partners. Second, the Saudis wanted to reel in Ahmadinejad. Crashing the oil markets threw Iran's budget into disarray and temporarily limited the regime's ability to spend money freely on weaponry and nuclear technology. Iran entered a crucial presidential election year having sustained a devastating and unexpected reversal of economic fortune. The fraudulent outcome of its midyear election was accompanied by economic contraction and the worst political unrest since the fall of the Shah three decades earlier.
One year ago, Prince Turki warned that Saudi Arabia was once again prepared to turn the oil markets against Iran. I noted in an earlier column that some industry analysts are skeptical that the Saudis really are capable of following through on such a threat. Nonetheless, Reuters reported this week that Saudi oil production finally surpassed the crucial psychological threshold of ten million barrels per day. Saudi production is not solely to blame for the second quarter's sharp fall in oil prices -- the weak performance of the U.S. economy and the on-going crisis in the Eurozone are also driving the price decline -- but if the Saudi trickle turns into a flood we may see a repeat of the price collapse of 2008-09. A Reuters headline from this past week says it all: "Oil Heads for Worst Quarter Since 2008 Crisis."
Then there's all that stockpiled oil to consider. Will the Americans and the Saudis dump their surplus oil on the market? At what point will the Iranians, faced with a fiscal shortfall, decide to offload their own massive stockpile of unsold petroleum? The oil markets have softened in recent weeks. That does not bode well for Iran's economy, regardless of protestations that it can weather the coming financial storm.
The Islamic Republic has proven its resilience over the past three decades. It has survived a devastating war, political turmoil, acts of sabotage, sanctions, and international isolation. The case can be made that the Pahlavi monarchy was in its own way as resilient as its forebear. Today we forget that during his 37-year reign on the Peacock throne, Mohammad Reza Shah Pahlavi survived British and Russian invasion and occupation, numerous assassination attempts, Communist interference, American manipulation, and waves of political and religious unrest. In the midst of all these challenges, he still managed to impose sweeping social, economic, and political reforms that upended Iran's old order and transformed the country into a regional power and military and industrial giant.
But the Shah also learned that there was one thing he couldn't control: the oil market.
by the same author | Iran's Economy: Once More to the Precipice
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