Last year saw a massive reversal of fortunes in terms of crude oil prices, with the commodity hitting its all time-high in July and a four-year low by mid-December. Such sharp price volatility has resulted in production being massively slowed and expectations that the price of crude oil may drop much further before it regains anything like a stable price.

While banks and financial services firms saw their investors either flee or turn nasty after the institutions continued to post ever larger losses and faced the prospect of being bailed out or bought out, the commodities markets saw a rapid growth in shareholder interest, pushing oil prices higher and higher.

In July 2008 crude oil prices reached a record high of $147.27 a barrel and the Organisation of the Petroleum Exporting Countries (OPEC), the powerful oil cartel whose members account for around two-thirds of the world’s oil reserves, and other producers seemed indifferent to the consequences. Few would have predicted then that before the year was over oil prices would drop by nearly two-thirds, languishing around the $45 a barrel mark and over $100 less than its peak at the start of 2009.

By the end of the year it became apparent that something drastic needed to be done and that earlier measures to halt price volatility were not working. In an effort to stem the drop, on 16 December Saudi Arabia called for the single largest production cut in the history of the oil cartel to counter oil prices from plummeting further. Saudi’s oil minister, Ali al-Naimi, called for cuts of about two million barrels a day – on top of the two million cuts already pledged in stages over the previous three months – to offset the effect of the global slowdown on demand for oil.

Arriving for OPEC’s policy meeting in Oran, Algeria, Mr Naimi said that the cartel had already delivered 1.7m b/d of the first run of cuts, with Saudi Arabia contributing by far the biggest share of 1.2m barrels. OPEC hoped to get other big producers, such as Russia, to commit to a further reduction of as much as 600,000 b/d, but while Russia has agreed to follow OPEC’s lead, traders have so far doubted that the goal can be achieved in anything more than rhetoric. As a result, OPEC was again unable to stabilise the falling oil price. And coupled with fresh concerns about the global economy, particularly as more countries revealed that they faced a recession in 2009, by 19 December oil prices continued to tumble, trading below $35 a barrel, hitting their lowest level since February 2004.

Continuing to slide
Moreover, the slide could continue into 2009 and see present prices nearly halve, say analysts. US bank Merrill Lynch believes that oil prices could fall as low as $25 a barrel in 2009 if the recession hitting the US, Europe and Japan extends to China, the world’s engine of commodities demand growth in the past few years. Francisco Blanch, head of commodities research at Merrill Lynch in London, said his main scenario was for oil prices to average $50 a barrel next year but warned that “a temporary drop below $25 is possible if the global recession extends to China.” “In the short run, global oil demand growth will likely take a further beating as banks continue to cut credit to consumers and corporations,” Mr Blanch said, adding that oil prices were likely to hit a floor in the first half of next year.

Merrill Lynch’s $50-abarrel forecast is one of the lowest among banks and consultants and such a price would cripple the domestic economies of most of the world’s largest oil producers. The drop in prices highlights the rapid global economic slowdown and its impact on oil demand, which in 2008 fell for the first time in 25 years. For example, total US oil demand over 2008 was down one million barrels a day compared with the previous year. The last time demand dropped this much was in 1981, on the eve of the recession that was – until now – known as the “worst recession since the Great Depression”.
Shokri Ghanem, Libya’s most senior oil official, has suggested that the production cuts announced in Oran, Algeria, will start to stabilise the oil market once they took effect in early January 2009. Ghanem added that OPEC ministers would review the market in January and would decide then whether the cartel might need an extraordinary meeting ahead of its next scheduled gathering in mid-March in Vienna.

Just volatile pricing
Oil prices are a barometer of the world economy and economists say that rising prices between 2003 and 2007 reflected the best global economic growth in a generation. But the tight balance between supply and demand – that OPEC has until now been so adept at managing – was not the only factor driving the increase in oil prices. Economists now believe that this high economic growth was brought to an end not only by the under-pricing of risk, excess liquidity and over-confidence, but also by an increasingly unsustainable commodity boom – of which oil was a crucial part – which began in the late summer of 2007 as a weakening dollar set off a “flight to commodities”. But experts also point out that, despite the price of oil dropping by over two-thirds in the last six months of 2008, a price “collapse” to the $50-$70 range is a collapse only if one forgets that the average oil price in 2007 was $72 a barrel (and $66 in 2006). Therefore, they argue, there has not been any real collapse in the market – just volatile and opaque pricing.

However, the sharp decline in the price of oil has resulted in a growing awareness among both producers and consumers that the volatility that took prices from $60 a year ago to more than $140 in July, before the current slide began, has damaged everyone involved.

The sharp rise, accompanied by wild predictions from the likes of investment bank Goldman Sachs that prices would continue to rise to $200 (or even $250 according to the Russian energy giant Gazprom) helped destabilise economic activity through the spring and early summer. Price increases led to a sudden transfer of wealth from economies large and small while the risk of inflation constrained governments anxious to stimulate faltering growth. Furthermore, inaction contributed to the loss of confidence in important asset prices.

The volatility in oil prices – reflecting fears and expectations (such as what may happen to supplies from Russia or Iraq) rather than physical realities – has prompted the UK’s prime minister Gordon Brown to tell world leaders that “such volatility is in no-one’s interests,” adding that “such fluctuations damage producers and consumers alike.”

To try to restore oil pricing stability, Ed Miliband, the UK’s energy secretary, has proposed new rules to force greater disclosure by traders in the oil futures market as the government continues to blame financial investors for contributing to the soaring oil price in the first half of the year.

A taskforce of the International Organisation of Securities Commissions, chaired by the UK and the US, is investigating commodities markets and will report in April. Mr Miliband has said that he did not want to pre-judge that inquiry by making detailed proposals, but he has also made it clear that he wants new standards to improve disclosure.

“In other markets, there is greater transparency about people’s positions and about the transactions that are taking place,” he said. “Given that the oil futures market has become more important to the oil price, it is important to look at ways to bring greater stability to the market with greater transparency.”

Saudi Arabia has been particularly vocal in its argument that it is the speculators, not the oil producers, who should be blamed for the high prices. Other studies have also rejected the idea that financial investment has had a significant influence on the market. For example, last July, the US futures regulator, the Commodity Futures Trading Commission, produced a report into the issue, concluding: “To date, there is no statistically significant evidence that the position changes of any category or subcategory of traders systematically affect prices.” Anthony Belchambers, chief executive of the Futures and Options Association, which represents participants in the derivatives markets, said: “The view of the CFTC and the findings of other reports show that speculation had no appreciable effect on long-term price movements and our view is that unless we are shown very clear evidence that is very much our view.”

He added: “We would go further and say that the role of financial trading in all commodities markets is critically important to sustaining liquidity and facilitating the hedging activities that commercial markets need.” He is also calling for more transparency in the oil market, to improve information such as levels of inventories, and is backing an attempt to give greater certainty on plans to invest in oil production.

Whether the fault for price instability lay with producers, speculators or both, for producers and exporters the pain of price volatility is just beginning. At current levels a number of OPEC producers cannot cover their national budgets. Iran and Venezuela, for instance, need a price of $90 a barrel to sustain current spending. Other countries have suggested that slightly lower oil prices are appropriate. For example, Saudi’s oil ministry has said that a $75 target was “fair and reasonable” as it was the “price that marginal producers need to maintain investments sufficient to provide adequate supplies for future oil consumption needs”. The country’s oil minister Mr Naimi also warned that without the investments “the world would see extreme swings in prices”, adding that “today’s price levels are wreaking havoc on the industry and threatening current and planned investments.” Having grown accustomed to high prices, countries such as Russia and Nigeria also face difficult adjustments.

As a result of the current low oil price, the stage could be set for a painful downturn and possible political unrest in 2009.

In the longer term, investment has also been damaged by uncertainty surrounding prices. Expensive ventures in ultra-deep water, the Arctic and the processing of oil shales are not viable at $45. For some of the oil groups balancing dividend payments and new investment begins to look tricky. Meanwhile state companies, which according to the latest study by the International Energy Agency must provide 80 percent of the incremental oil and gas needed from now until 2030, find themselves squeezed by sponsoring governments distracted by meeting more immediate spending requirements.

More than a downturn?
Arab oil producers are likely to feel the downturn in oil demand and oil prices more sharply than other producers, say analysts. As Gulf states’ earnings ballooned in recent years on the back of soaring oil prices, their governments began to adopt a prudent policy of saving and diversification. Unlike in previous oil booms, this time they seemed determined to improve the foundation of their economies in a bid to ensure they withstood future oil price shocks.

But now the financial crisis and the dramatic collapse in oil prices look set to endanger plans to transform their economies – a process deemed critical to providing private sector jobs for growing young populations. Even in the United Arab Emirates, where diversification is relatively advanced – not least because of Dubai’s efforts to establish itself as a business hub – oil contributes around 40 percent of gross domestic product. Not surprisingly, when observers seek to gauge the overall health of the UAE, they look closely at Abu Dhabi, the capital, which is home to more than 90 percent of the nation’s oil and gas reserves. But even that wealthy emirate is feeling the effects of the global storm. Hussein Nowais, a senior Abu Dhabi government official, has said that “you cannot just rely on oil. We have had the good times because of oil and we should be strong enough to weather the storm.”
Dubai, meanwhile, has acted as a platform for the channelling of petrodollars through its financial hub, and many of the investments in its real estate sector have come from wealthier neighbours. As a consequence, it faces the prospect of declining oil prices as well as a global downturn in trade, finance and tourism.

Given their hydrocarbon riches, governments throughout the region have targeted energy-intensive industries such as petrochemicals, aluminium and steel as a means to diversify, hoping to create jobs in downstream sectors.

But those industries have also been hit by the global slowdown, while low crude prices will dampen sentiment towards the region following a period of petrodollar-fuelled hype.

“The paradox is that what has enabled the diversification is the oil price boom. If it’s not there, there will have to be a slowdown,” says Marios Maratheftis, regional head of research at Standard Chartered. “Diversification is a long-term process and Gulf states have attempted it, but they have not fundamentally diversified and have not moved fast enough,” says John Sfakianakis, chief economist at Saudi Arabia’s SABB, who compiled the numbers.