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The price of crude oil needn’t be as low as it is today – in the neighborhood of $50 per barrel – except that OPEC decided nearly a year ago to keep it low to in an effort to make shale production unprofitable and restore the cartel’s market share.
The strategy may be working, but it has some unwanted side effects on the cartel’s core producers in the Middle East. Not only are budgets out of balance, but now the region’s stock markets are being affected.
It was the prodigious production of shale oil, mostly in the United States, that caused the price of oil to fall from more than $110 per barrel in June 2014. But it was OPEC’s decision five months later to maintain its production at 30 million barrels per day that drove it to its current low point.
Related: Don’t Expect A Breakout In Oil Prices Any Time Soon
It was a price war declared against shale producers, who rely mostly on hydraulic fracturing, or fracking, to extract shale oil. The process is more expensive than conventional drilling and isn’t profitable if the price of a barrel of crude falls below a threshold of about $60. And the strategy is having its effect on North American extraction.
But it’s also led to lower revenues for OPEC members. The cartel’s pricing maneuver, the brainchild of Saudi Oil Minister Ali al-Naimi, was predicated on rich Gulf States being able to weather a temporary drop in income. When the strategy went into effect, for example, Saudi Arabia’s treasury had a financial reserve of about three-quarters of a trillion dollars.
Not only were less affluent OPEC members such as Venezuela hurt by the lower oil prices, but even Gulf States, including Saudi Arabia, began to feel the pinch almost immediately and revise the projected revenues of their budgets for the fiscal year 2015.
Related: Low Oil Prices Could Persist Through 2016
And on Oct. 30, the U.S. financial services company Standard & Poors (S&P), citing a “pronounced negative swing” in Saudi finances due to lower oil revenues, cut its rating of the Saudi sovereign debt to ’A+/A-1’ from ’AA-/A-1+,’ and said its outlook for Saudi Arabia remains negative.
In announcing the downgrade, S&P observed that the kingdom had budget surpluses of about 13 percent of gross domestic product in the 10 years leading up to 2013. Since the price of oil began its plunge, however, the agency said that surplus will become a deficit of 16 percent of GDP by the end of fiscal 2015.
A downgrade in debt rating makes borrowing more expensive for the affected company or country.
Still, Saudi Arabia probably will suffer little, if any, financial repercussions for two reasons. First, the other two major rating companies, Fitch and Moody’s, have maintained higher ratings for Saudi Arabia. Second, the Saudi government and Saudi-based companies have little foreign debt.
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But the impact on the Middle East overall has already been negative. On Nov 1, stock markets in the region fell because of investors’ concern that the Saudi government will have to reduce spending even further in fiscal 2016 if oil prices remain low to limit its budget deficit.
Markets fell in Saudi Arabia, Dubai, Abu Dhabi and Egypt, though stocks rose slightly in Kuwait, Oman and Bahrain, where trading is traditionally light and therefore less susceptible to market swings elsewhere in the region.
At its last policy-setting meeting in November 2014, OPEC decided to move ahead with its pricing strategy despite what it perceived as its short-term costs. Now those costs may be incurred over a longer term. It will be interesting to see how the cartel addresses the problem at its next major meeting on Dec. 4.
By Andy Tully of Oilprice.com
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Andy Tully is a veteran news reporter who is now the news editor for Oilprice.com