SINGAPORE (Mar 19): Oil prices are a key determinant of the health of the global economy and they matter a lot to this region. But predicting oil prices is a difficult task. During the commodity price boom of 2006 to 2008, the price of the benchmark Brent crude oil more than doubled to US$145 a barrel, before easing to around US$100 in 2014 and 2015 and then crashing to a trough of around US$28 around January 2016. Since then, the price of the benchmark Brent crude oil has more than doubled to around US$62 today.

Looking at the fundamentals of supply and demand, we believe that oil prices should fall further, perhaps by about 10% to 15%, in the coming year. However, these forecasts could turn out to be wildly wrong if political risks, particularly in the Middle East, were to materialise.

Supply likely to rise in the next one to two years

There are two important drivers of oil supply — new sources of oil and whether the oil cartel, Organization of the Petroleum Exporting Countries (Opec), can maintain enough discipline to keep to its production quotas. Both factors suggest a possible downside in oil prices:

<ul><li>New supplies flowing into markets: The International Energy Agency’s recent annual oil report projected a strong outlook for oil supply up to 2020. Expanding production in the US, Brazil, Canada and Norway is seen as sufficient to satisfy the expected growth in global oil demand up to 2020. The key to this positive outlook is the US. Such is the strength of the American shale revolution that the US alone is seen as supplying 80% of demand growth in 2018 to 2020. Indeed, US oil production reached a record high of just above 10 million barrels a day in November 2017 — and the IEA believes that the US will overtake Russia to become the world’s largest oil producer by 2023. Some analysts question whether US shale production can really continue growing when so many of the best drilling locations have already been exploited. However, US shale producers have demonstrated an impressive ability to use technology to make more and more shale reserves exploitable at ever lower break-even price levels, so we would not bet against US shale.</li><li>Opec will struggle to maintain discipline: The dramatic surge in US shale oil production has weakened Opec’s ability to shape the world oil market. Still, Saudi Arabia has spare production capacity of roughly two million barrels of oil, and this makes it a powerful force in the oil market. The Saudis and non-Opec member Russia have learnt to work together to keep oil prices from falling further and, so far, their co-operation has helped contain the downside risks to oil prices. But several Opec members such as Iran, Iraq and Kuwait have been investing in new production capacity and are eager to reap the benefits of such investment. Non-Opec members such as Ghana and Kazakhstan are also expanding capacity. With the rapid development of renewable energy posing a long-term challenge to oil, oil producers’ calculations have changed: In the past, those with massive reserves had preferred to leave much of it in the ground so as to benefit from the expected long-term rise in oil prices, so they did not mind Opec production cuts from time to time, which preserved the long-term value of their oil reserves. Now, that prospect is much less certain and it might make sense to aggressively exploit oil reserves before they potentially lose value in the long term. There are also deep divisions among Opec members that undermine Opec discipline. Saudi Arabia and Iran, for example, are battling for regional hegemony, reducing trust and co-operation.</li></ul>

Almost 10 years after the global financial crisis, the world economy is finally normalising. As credit, housing and labour markets are returning to normal and business confidence is returning, spurring a revival in capital spending, which adds a new engine of global growth. Moreover, across many countries, fiscal spending is being ramped up after many years of slowing. In the US, substantial tax cuts and stepped-up spending in both defence and other areas will drive growth even higher. Germany’s new coalition government is also planning more spending, and that is likely to be repeated in other European countries such as Italy. In other words, global growth — and therefore oil demand — could surprise on the upside.

That would be positive for oil prices, but now there is a new factor — the growing substitution of oil by renewable energy, especially solar and wind energy, which already accounts for about 20% of global electricity production. This will grow — the World Economic Forum has observed that the world is on the cusp of “adopting clean energy at a scale never seen before”. The costs of solar and wind power have been falling and making them more competitive against fossil fuels. Now, advances in battery storage technology are making the use of renewables even more attractive and so enabling renewables to substitute for oil and coal more powerfully. Other trends such as the growing case for waste-to-energy are also creating more substitutes for oil.

So far, so good — there is a good case to be made for oil prices to edge lower in the medium term at least. The one thing that could substantially change the picture is politics. Sadly for us, the Almighty chose to place much of the world’s oil in regions with a high chance of political convulsions — especially in the Middle East. Just a quick survey of political risks will bring this out:

<ul><li>In Venezuela, oil production is falling as the country lurches from crisis to crisis. Mismanagement has reduced the national oil corporation to a pale shadow of what it used to be. The deepening malaise has raised the chance of a political and economic collapse that could take oil output much lower than the two million barrels a day it produced in 2017 — about 3% of global oil production. That was already down 13% in 2016 to a 28-year low, but it could get even worse.</li><li>In the Middle East, the growing tensions between Iran on one side and Israel and Saudi Arabia on the other appear to be reaching a breaking point. Israel sees Iran’s growing military presence in Syria and Lebanon as an intolerable threat and has threatened to target Iran in response. Separately, Saudi Arabia and Iran are locked in proxy wars, each backing different sides in civil wars in Syria and Yemen, for example. The US is also being drawn into this arena given the Trump administration’s hostility towards Iran and its threat to scupper the Obama administration’s deal with Iran that curbed its nuclear weapons programme. Then, there is the Saudi-led coalition of Persian Gulf emirates that has targeted Qatar for its alleged support of extremists. In short, there are many reasons why we could see political troubles that threaten the production and/or transport of oil in this unstable region.</li><li>Other large oil producers also face instability risks. Nigeria, for instance, produces about 2.1 million barrels of oil a day, most of it from the Delta region, which has been a hotbed of separatist insurgency. A pact with the rebels that allowed oil production to resume could be at risk, with some militant groups recently threatening to resume violent attacks.</li></ul>

So long as political risks are contained, oil prices should head lower over 2018, with important consequences for our region:

<ul><li>Economic growth: In the near term of the first one to two quarters, a fall in oil prices might be contractionary. Oil-producing nations and the oil companies will tend to cut spending immediately as their revenues fall — but oil consumers tend to wait for some time to see how permanent the fall is before they step up their spending. But, over time, there are many more oil consumers than producers and so lower oil prices should boost global economic growth. Lower oil prices improve spending power for consumers while reducing production and transport costs for businesses that then make larger profits. Within Southeast Asia, Malaysia is the only net oil producer, but the others are net importers that will gain. Even Malaysia will be a net gainer because its exports of non-oil/gas items are so much larger than oil/gas exports. India, Korea and Thailand are huge importers of oil for their energy needs, so they will tend to be the biggest winners. Interestingly, Singapore has a huge dependence on oil for its primary energy needs — 86% according to the BP Statistical Review of World Energy, so it will also be a big winner from lower oil prices.</li><li>Inflationary pressures abate: Lower oil prices tend to help reduce overall inflation. Oil-related items feature prominently in the basket of goods used to calculate the consumer price index, so oil prices have a noticeable impact on inflation expectations. India, Thailand, Indonesia and Malaysia have the highest weight of oil-related prices in their CPI, so they will tend to be the main gainers.</li><li>Current account deficits can improve: As most of the region except Malaysia are net oil importers, lower oil prices will help reduce import values and so improve trade and current account balances. This effect will be prominent for India and Indonesia.</li><li>Fiscal revenues and spending are also impacted: Countries that still provide fuel subsidies such as India and Indonesia will see the costs of these subsidies come down, which will improve their budgetary balances. In short, the prospect of a fall in oil prices will help boost growth, contain inflationary pressures, improve the external accounts and strengthen the fiscal position.</li></ul>

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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