The geopolitics around us -- mainly Iran and Nigeria -- are keeping oil prices aloft. But should traders lose the fear of Tehran closing the Strait of Hormuz, and Nigeria's Goodluck Jonathan not managing to make peace with his striking countrymen, look for the air to go out of prices that, despite the continuing European economic crisis, exceed $100 a barrel. And if they drop far enough -- into the low-$80s-a-barrel range -- some key petro-states are going to be in serious trouble, according to a couple of analysts from the Eurasia Group.
In a blog post at the Financial Times, Eurasia's Chris Garman and Robert Johnston scrutinize Russia, Nigeria, Venezuela and Saudi Arabia. Garman and Johnston's presumption is that oil demand remains soft in the U.S. and Europe, and erodes the impact of an expected rise in Asian oil consumption. As a result, Saudi Arabia attempts to retain a floor under prices by reducing production, but that just creates a vicious circle: Lower actual Saudi production necessarily means higher idle production capacity, also known as spare capacity. As far as petro-states are concerned, that is a deadly brew.
Oil prices are determined at precisely that inflection point -- spare capacity. Oil traders in London and New York compare global oil demand and the capacity of petro-states to meet it, and if the gap between the two numbers is exceptionally narrow -- if there is barely enough production capacity to satisfy demand -- then traders will bid up the price. When they do so, they are betting on the blowup risk of an event like anti-Iranian sanctions or Nigeria's street protests, and the loss of existing oil exports. This risk is based on the following question: Do or do not states such as Saudi Arabia possess sufficient spare capacity to make up for those lost exports?
Similarly, if the gap between the numbers is super-wide -- such as would occur this year in the Eurasia scenario -- traders will bid down the price, since it almost wouldn't matter what geopolitical event occurred: There is still plenty of spare capacity to compensate for almost any loss of production.
Starting with Russia, such a scenario -- Eurasia's soft oil price forecast -- would weigh heavily on strongman Vladimir Putin. Five years ago, when Putin launched a period of full-throated vitriol against the West, he was animated by rising oil prices that exceeded state budget requirements, allowing Russia to pay off its debts for the first time in decades, and to build an enormous cash reserve. Now, in the throes of a political campaign toward presidential elections in March, Putin has rehabilitated his pugilistic instincts in regular tongue-lashings aimed at the United States. But it is against a wholly different economic backdrop, according to Eurasia: Prices are not as high relative to state spending as they were a few years ago.
The Kremlin forecasts that oil prices will average $100 a barrel this year, well below the $126-a-barrel level that the state budget requires in order to break even. Unlike in 2007 and 2008, Russia will have to borrow money through the sale of Eurobonds in order to fund its deficit. After Putin's presumed election victory, his tough talk will look threadbare, lacking the muscle of surplus spending dollars.
As for the others, Saudi Arabia requires $85-$90 a barrel to break even. Venezuela's budget requires some $110 a barrel, and that is before President Hugo Chavez (pictured above with Iran's Mahmoud Ahmadinejad, who also faces tough budget challenges) presumably boosts state spending in the runup to October elections. Nigeria, interestingly, is a haven of oil-price sobriety within this group. Goodluck Jonathan, the country's president, is operating off an assumption of $70-per-barrel prices. The downside risk for him, in Eurasia's view, is if Niger Delta instability cuts into oil exports.
But it may be an even bleaker picture for these petro-leaders than Eurasia portrays. According to inflation-adjusted, back-of-the-envelope calculations by Geoffrey Styles at GSW Strategy Group, last year's average oil prices are about equivalent to their 2008 peak of $147 a barrel. Meaning that these petro-leaders are already treading water despite record prices.
In order to return to the black, they need a more profound set of crises than the world faced in 2006-2008 with the combination of Gulf of Mexico hurricanes, oil-patch kidnapping in Nigeria, almost zero spare capacity, the Iraq war, labor strife in Venezuela, a weak dollar, and surging Asian growth. And even then, they will only be breaking even. The trouble so far is that the message from oil traders is ho-hum.
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