The Fuse

Geopolitical Risk and Lost Production

by Matt Piotrowski | November 16, 2017

Geopolitical risk has returned to the oil markets and is a key reason prices have rebounded to above $60 per barrel. What’s clear is that the turmoil taking place in the Middle East and elsewhere will continue to loom over the oil market for the foreseeable future. The oil market is right to worry about supply outages from geopolitical events or instability in major oil-producing countries. When producers that are inherently prone to conflict and resource nationalism lose supply, output will most likely not return to previous levels (see below).

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Even if production does rebound, the recovery process is typically lengthy, which means the global oil market has to cope with reduced supply. Every producing country has its own unique reasons for its problems, but stringent contract terms, the lack of technical expertise from outsiders, civil wars, violence against infrastructure, above-ground political risks, and resource nationalism are all factors that dampen investment and production. Foreign investors, who seek stable environments to hedge against risk, are often disincentivized to commit large sums of capital to projects in petrostates due to the looming specter of nationalism and political instability.

Venezuela’s supply woes worsen

The current situation in Venezuela is particularly worrisome. Crude oil production in the South American country has been on a steady decline due to mismanagement, nationalization of oil resources, a weakening economy, and corruption. In the late 1990s, the country’s oil output reached 3.4 million barrels per day (mbd), but it averaged just 1.9 mbd last month and is expected to decline further. As it stands currently, Venezuela’s oil production has fallen to a 30-year low, and output continues to decline as the socialist government struggles to repay its debt.

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Since the country’s woes are unlikely to reverse course, output may never recover to today’s levels, much less what was achieved two decades ago. “In Venezuela, persistent underinvestment, a wider economic crisis and continuing political instability mean it is unlikely to be in a position to increase production materially any time soon,” the International Energy Agency said in its latest World Energy Outlook.

Iran’s resource nationalism, and potential parallels in Libya and Nigeria

Iran is an example of a country failing to fully recover after supply dropped significantly.

Iran is an example of a country failing to fully recover after supply dropped significantly. In the late 1970s, before the Iranian Revolution, the OPEC producer saw its output reach 6.6 mbd. However, it fell sharply to below 2 mbd in the early 1980s. Although crude production has rebounded, it is still more than 40 percent lower than its peak. In 1979, the National Iranian Oil Company (NIOC) took control of the industry and kicked out foreign investors. Resource nationalism has been and remains strong in Iran, undermining investment while the country has also had to deal with decades of international sanctions. Iran is opening its oil fields to outsiders, but international oil companies (IOCs) remain skeptical because of an unstable political environment and other above-ground risks. Even if Tehran is successfully attracts investment from IOCs, it is uncertain whether the country can return to its previous peak.

Libya and Nigeria are two producers that are at risk of not seeing their production return to previous highs.

Others may suffer the same fate as Iran. Libya and Nigeria are two producers that are at risk of not seeing their production return to previous highs. In 2011, Libya’s oil production averaged 1.7 mbd, but fell to virtually zero when Muammar Qadhafi was overthrown. Since then, output has had an uneven recovery and is now just under 1 mbd. Given the dangers surrounding infrastructure security, militant factions, threats from ISIS, and limited investment, Libya still has a long road to full recovery. In Nigeria, oil production recently hit a 30-year low of 1.3 mbd. That is down from the 2.6 mbd achieved last decade before militant attacks disrupted oil facilities on a regular basis in the Niger Delta. The ongoing threats from militants, along with the economy slowing from low oil prices, could lead to a slow recovery in production. In fact, Nigeria, like others, may not return to previous levels.

Syria certainly falls in this category, too. In 2011, before the country descended into civil war, it was producing approximately 400,000 barrels per day (b/d), and output was near 600,000 b/d in the mid-1990s. Given the devastation from years of war, the country’s oil sector is unlikely to recover even though it is sitting on about 2.5 billion barrels of reserves.

Uneven rebounds in Iraq, Kuwait & Russia

Some countries are fortunate enough to see their production rebound to earlier levels. Iraq, Russia, and Kuwait, after dealing with sharp declines, have experienced strong recoveries. For instance, Russia’s output fell after the fall of the Soviet Union. It declined to below 6 mbd in the late 1990s, but has climbed steadily and recently hit 11 mbd. Moscow plays a large role in the country’s oil sector, but it has used joint ventures with IOCs to expand production. Moreover, Russia’s resurgent production has been enabled by a massive influx of capital into the country’s energy sector, including from recently-struck energy deals with Saudi Arabia and China.

When production recoveries do occur, they are usually long, drawn-out efforts.

Iraq’s output reached 3.5 mbd in the early 1990s, but did not achieve this level again until early this decade. After the U.S. invasion, Iraq disappointed as it opened up to outsiders slowly and was undermined by bureaucratic delays. Sectarian strife also slowed the country’s potential. With the country seeing relative stability (despite the ongoing tensions between Baghdad and Erbil), production has surged past 4.5 mbd. And Iraq’s growth is expected to be the sharpest in the Middle East over the next couple of decades.

Kuwait’s oil fields were set on fire when Saddam Hussein invaded the country in 1990 and millions of barrels of oil spilled into the Persian Gulf. Even though Kuwait’s oil industry was badly damaged, the billions poured into reconstruction helped production return to above 2 mbd by 1993. Kuwait’s swift recovery is an anomaly. Most recoveries, such as the ones in Iraq and Russia, were long, drawn-out efforts.

The effects on price, spare capacity

 Lower output from major producers increases the risks of supply shortages when the market tightens.

This lost production is important for a variety of reasons. Most notably, lower output from major producers increases the risks of supply shortages when the market tightens. Spare capacity drops, weakening the market’s ability to guard against future supply shocks. The market was fortunate to have a large supply overhang over the past three years, but now that inventories are declining and OPEC has reduced production, lost supply carries greater weight. Small shortfalls can have an outsize price impact. There’s also the risk of underinvestment. The countries that have dealt with sharp declines and unexpected supply outages have enormous resources and their output is necessary to keep up with rising demand. The stability of oil-producing countries is important for the market, as the consequences for volatility in oil prices have enormous medium- and long-term implications.

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