Moisés Naím / World Energy & Oil

A sudden, significant and prolonged change in the price of oil changes the world. It happened in 1974 and is happening again now. In March of 1974, the price of oil had surged from 3 to 12 dollars per barrel. The new price created new global economic powers: the oil producing countries primarily in the Middle East and North Africa. It also dealt a severe blow to the economies of the United States, Europe, Japan and other oil importers. The oil shock altered the power relations between the main geopolitical players and created new ones. Higher oil prices had many unexpected consequences—from breeding oil wars to contributing to the international spread of Islamic fundamentalism thanks to the funding of newly superrich countries like Saudi Arabia. The world is now discovering that the substantial, sudden and totally unexpected drop in the price of crude oil may be as disruptive as the quadrupling of oil prices that created the oil shock of 1974.

THE OIL SHOCK OF 2015
Some of the world-changing effects of the substantial drop in oil prices that began in the summer of 2014 were immediate and clearly visible. Happy gasoline consumers in the United States and elsewhere are an example of this impact as are worried governments in oil exporting countries faced with the need to cut their public budgets and risk social and political turmoil as a result.

Two illustrative examples of the direct impact of lower prices in oil exporting countries with economies that were already weak and suffered an additional blow by the decline in oil prices are Russia and Venezuela. Russia’s Ruble has suffered a steep devaluation, stock market prices in Moscow have fallen, the Central Bank’s reserves are dropping, capital is fleeing the country, export revenues are down and foreign investment has practically halted. Russia’s sovereign bonds have been downgraded to junk by credit rating agencies. All of this is, of course, largely caused by the decline in oil revenues (68 percent of Russia’s total exports and 50 percent of public budget revenues) and the economic sanctions imposed by the United States and Europe as a result of the Kremlin’s behavior with respect to Ukraine. The fear, of course, is that a belligerent Vladimir Putin will stir troubles abroad to distract from the deteriorating economic situation at home.

In Venezuela, the economy was in shambles when oil was at 120 dollars per barrel and is spinning out of control as a result of rampant corruption, woeful management and lower oil prices. Yet, President Nicolas Maduro has repeatedly stressed that the dire situation is caused by an international conspiracy led by the United States and has reacted by ramping up the attacks on his critics and the repression of opposition politicians.

Low oil prices can stir dangerous international conflicts by leaders in need of a distraction from their dobymestic unrest, while in other countries they can create conditions for needed but long postponed reforms. Sadly, they can also lead governments to become more repressive at home and aggressive abroad.

THE SECOND ORDER IMPACTS
The initial and more direct impacts are themselves having consequences of their own. These second order effects of lower oil prices (“the consequences of the consequences”) are only beginning to become apparent. Recent headlines give some clues about the world to come if oil prices remain low for a prolonged period. Chevron cancelled a $10 billion shale gas exploration project in Ukraine. The government in Kiev was counting on that project to help stimulate its troubled economy and, once completed, to lower its dependency on Russian gas. This is just one concrete example of a broader trend: scraping or postponing energy projects that have suddenly become too risky or not economically viable at a lower price level. Exxon- Mobil announced that it was slashing its capital expenditures by 12 percent this year. And this is an industry- wide trend: According to Goldman Sachs, $1 trillion worth of planned investments in energy projects are now under review or have been cancelled. In the long run, this may mean less production and higher energy prices, but in the short run the sudden disappearance of this enormous investment flow is bound to hurt energy companies and especially their equipment suppliers and the construction and engineering firms that were to execute these projects. It will also hurt the cities and regions where these companies operate – from Texas to Nigeria.

SEIZING THE MOMENT TO CUT OIL SUBSIDIES
Not all the second order consequences of lower oil prices are negative. Take for example this comment included in a report about Malaysia’s economy that was recently issued by the International Monetary Fund: “After raising electricity tariffs in early 2014, the government took advantage of lower energy prices in the second half of 2014 to reduce and ultimately remove remaining gasoline and diesel subsidies. [This] should also help broaden the base of federal revenue system and diversify it away from volatile oil and gas revenues. A strengthening of Malaysia’s social safety net is an integral part of the authorities’ fiscal strategy. The removal of subsidies freed up resources that can be redirected to better support poorer households through better targeted cash transfers.”

The same happened in India and Morocco. In India, the Modi government cut costly public subsidies of diesel fuel, which had been long known to be harmful but also politically unpopular to shed. Morocco, which was already planning to reform its highly inefficient set of subsidies, got a big help when its reforms were facilitated by the drop in oil prices. Energy subsidies are as common as they are harmful for the economy, for the poor and, of course, for the environment, as they stimulate consumption and undermine efforts directed at saving energy and using it more efficiently.

According to the World Bank, these subsidies are highly regressive: between 60 and 80 per cent of what governments in the Middle East and North Africa spend to subsidize energy go to benefit the richest 20 percent of the people, with the poor receiving less than 10 percent of these public funds.

Plummeting oil prices are stimulating a wave of reforms aimed at reducing or eliminating government fuel subsidies, which amount to more than $540 billion per year worldwide. The New York Times reported that oil producers such as Oman, Kuwait and Abu Dhabi have also started to implement subsidy cuts. The Indonesian government recently abandoned a four-decade-old policy of subsidizing gasoline. Even Venezuela, with the largest gasoline subsidy in the world, is contemplating an increase in domestic fuel prices.

Another potential benefit of lower oil prices is that it could cut the incentives to produce more polluting extra- heavy oil. Some of the largest oil reserves in the world are of this type, more expensive and technically more difficult to develop. Such is the case of the Venezuelan extraheavy oil reserves of the Orinoco river region. Due to their higher production and upgrading costs, the development of these reserves is likely to be postponed.

The problem of course is that lower oil prices are eroding the economic viability of cleaner energy sources like solar, wind, etc. Optimists hope that lower prices of oil and gas will encourage producers of renewable energy sources to improve their technologies and production methods, making them cheaper and more economically viable. This, in turn, will make renewable energy more commercially attractive once the price of oil rebounds.

LOW OIL AND HIGH FINANCE
Another area where lower prices will have surprising second order consequences is in financial markets. Lower oil prices can harm the balance sheets of energy companies by driving down the volumes of the proven reserves that are counted as commercially marketable assets by these companies. These reserves in turn are one of the main drivers of the companies’ market value. As oil prices drop, the higher production costs of some oil reservoirs will make them commercially unviable, and thus no longer qualifying as proven reserves. Such reservoirs will become a new kind of “stranded assets,” a trend already visible in some of the highercost oil fields across the planet. “Stranded assets” was a term originally coined to describe the volumes of fossil fuels that will not be used as climate concerns lead governments to limit their use as a source of energy. Lower oil prices can also create a significant inventory of “stranded assets” that will negatively impact the valuations of some of the world’s largest corporations.

Changes affecting global finances might also occur due to changes in the investment behavior of sovereign funds. Some of the world’s largest sovereign funds are those of oil and gas producing countries. The Norwegian fund, for example owns about 1.3 percent of all global securities. A prolonged depression in oil prices might force Norway to finance its fiscal shortfall with resources taken from its sovereign fund. This would naturally lead to the liquidation of sizable investments and thus exert a downward pressure on global equity markets. In fact, this $840 billion fund set up an expert group to evaluate if it should stop investing in fossil fuel companies, in anticipation that sizable hydrocarbon assets may lose significant value.

In addition to policy changes in the sovereign funds, many producing countries such as Nigeria, Kuwait, Iran and Kazakhstan, which own oil stabilization funds, have stated their intention to tap into these funds to fill the fiscal gap created by lower petroleum and gas export revenues.

The increasing financial constraints of state-owned oil corporations in producing countries, such as Mexico’s PEMEX, Brazil’s PETROBRAS, Russia’s GAZPROM, Nigeria’s NNPC, Argentina’s YPF and Venezuela’s PDVSA might lead them to offer better conditions and more attractive joint venture deals to private companies and foreign investors. In the private sector, the upheaval in valuations caused by lower oil prices can lead to a wave of mergers and acquisitions of energy companies. The possibility of some very large consolidation cannot be ruled out-an outcome that can deeply change the structure of the industry.

THE GEOPOLITICAL REPERCUSSIONS
Finally, there are many unexpected geopolitical consequences of lower oil prices. The relationship between Russia and Europe has been disrupted both by the conflict in Ukraine, which led to sanctions against Russia, and by the lower prices.

The cancellation of Gazprom’s South Stream pipeline across the Black Sea and Southeastern Europe is just one manifestation of a fluid situation that has surely changed the energy equation there. Also in flux is Russia's relationship with China. Matt Ferchen from Beijing’s Carnegie-Tsinghua Center for Global Policy envisions closer economic cooperation between the two large nations: “China’s calculations in terms of energy deals hinge on a more advantageous bargaining position over the price of oil…. Russia, now under fire from sanctions and a drop in commodity prices, needs a partner.”

In Latin America and the Caribbean, Venezuela's political influence is waning as a result of many factors, paramount among them that the Bolivarian government no longer has the same oil revenues that allowed Hugo Chavez to gain enormous influence by subsidizing oil supplies to friends and denying these supplies to foes. Countries that have been dependent on its largesse will have to look for alternatives, which might require engagement with other political forces in the hemisphere.

In the recent rapprochement between Cuba and the U.S., the collapsing price of oil also played a role. Venezuela’s economic crisis heightened the risk that the island would no longer be able to count on the enormous subsidy it has enjoyed for more than a decade from Venezuela. Cuba's regime was thus eager to find another source of support once Venezuela’s economic lifeline ended.

And of course, there is no other region in the world where the second order consequences of plummeting oil prices are more varied, important and unpredictable than in the Middle East.

“ISIS struggles to balance books as finances are squeezed” titled the Financial Times last February. The reporter Erika Solomon wrote: “The world’s richest jihadi group is not as flush as it once was… It has cut spending on fuel and bread subsidies, while increasingly shaking down locals for cash. Fighters themselves may be feeling the squeeze, too.” Analyst Torbjorn Soltvedt estimates the group’s daily revenues from oil have dropped to $300,000 per day. Last year, analysts estimated that ISIS made between $1m and $2m a day from oil. “I don’t think this will lead to their collapse. But it might accelerate their implosion.”

Another important actor for which oil prices matter a lot is Iran. There are many reasons beyond the price of its oil exports that led the regime in Tehran to engage in negotiations about its nuclear program with the United States and six other countries. But surely the fact that Iran is one of the world’s hardest hit oil producers must have some influence in the government’s stance in the negotiations. All of these effects, both the most direct and immediate and the longer-term and more indirect, hinge on two questions: how low will oil prices drop and how long this period of lower prices last? Estimating the future of oil prices is very risky. It is sobering to note that no expert, corporation, or government had anticipated the revolutionary drop in prices that started in the summer of 2014. But if there is someone whose job provides a perspective worth listening, it is Rex Tillerson, the CEO of ExxonMobil. Here is what he thinks: “The world should ‘settle in’ for a period of relatively weak oil prices… U.S. shale production is more resilient than many people had expected and demand growth in China and elsewhere has slowed. Those conditions could persist.”