Jonathan Eyal, Europe Correspondent, In London

Tussle over falling oil prices

Lower oil prices are reshaping the energy market, as Middle East countries try to fend off competition from US shale gas.

Sooner rather than later, what went down must come up. That's at least the hope of the world's oil exporters, who are getting desperate as their products are now fetching the lowest prices in years.

Oil prices are famous for their unpredictable fluctuations and their sensitivity to political crises so, no doubt, the prediction will be proven right.

Still, the current sharp drop in energy prices is more than just a matter of market flutters. It is an indication of a bigger shift in the balance of power between producers and consumers, and the changing financial importance of different continental markets. This is no ordinary energy price war of the kind witnessed in the past, but a broader tussle which will result in more profound strategic realignments.

Right now, the world is awash with oil, and markets have responded in the only logical way, by marking the price of this crucial commodity down, from a peak of US$115 (S$148) per barrel in June to little more than US$80 today. The reasons for this price decline - the steepest in a decade - are obvious: better-than-expected production in war-torn Libya and Iraq, Iran's return to the oil export markets, and a global economic slowdown.

The normal response to such developments is to cut production: manipulating supply in order to ensure optimum rates of return was the key rationale for the foundation of the Organisation of Petroleum Exporting Countries (Opec), a 12-nation cartel of mainly Middle-Eastern nations.

Although Iran and Venezuela are indeed now calling for immediate cuts in oil extraction, Saudi Arabia, Opec's biggest producer, has rejected appeals to cut the amount of oil it sells, and other Gulf producers have also refused to cut their production.

How does one account for this curious Saudi behaviour which not only makes Opec appear impotent, but also costs dearly in terms of lost revenue?

Oil traders and Middle East watchers, always prone to give credence to conspiracy theories, think they have discovered the explanation: allegedly, the desert kingdom has forged a secret deal with the United States to keep prices down in order to punish Russia for its military intervention in Ukraine, and squeeze Iran. The Russians take this conspiratorial explanation as an established fact: "Obama wants Saudi Arabia to destroy the Russian economy", read a recent headline in the Pravda daily newspaper in Moscow.

Countering the US

BUT all this is nonsense since, far from coordinating its oil strategy with Washington, Saudi Arabia's current behaviour is actually designed to counteract the emergence of the US as a commercial rival in energy products.

The Saudis have feared for a number of years that the US production of shale oil and gas through novel geological recovery techniques which involve bombarding rocks with water, sand and chemicals in order to force the energy resources to the surface, could reduce US dependence on oil and gas imports. But they were shocked to discover just how fast this process was accomplished: "When it comes to crude oil and other hydrocarbons, the US is bursting at the seams", claims a just-released energy report from Citi, the bankers, who predict that the growth in US production will continue exponentially.

As far as the Saudis are concerned, this amounts to a triple-whammy of bad news.

First, the loss of the US as a market is painful not only in economic but also in strategic terms: an America which no longer needs Saudi products may no longer be interested in defending the monarchy either. Furthermore, Saudi oil - especially its so-called "sour" variety - was particularly suited for refineries in the US; finding new markets for it won't be easy.

And if this was not enough, the US could soon emerge as an exporter of oil and gas in its own right: it is already predicted to overtake Saudi Arabia in overall production quantities as early as next year.

By keeping prices down, the Saudis hope to squeeze US shale oil and gas operators and thereby prevent US production from rising. Recent research from Deutsche Bank has suggested that around 10 per cent of all US shale oil won't be economic to extract at prices below US$90 per barrel, and no less than half of all the US oil would be uneconomical if prices drop below US$80.

Since Saudi extraction costs are far lower, the desert kingdom may be ready to drive prices further down in the hope that, if this does not eliminate US shale oil producers, it would at least alert US producers about the vagaries of the business, and thereby deter them from expanding.

The Saudis may also be hoping to get a deal with the American administration under which the US will promise to retain its current ban on shale oil exports.

That's history stood on its head: previously, oil producers used to increase their oil prices if they wanted to squeeze concessions out of Washington; now, they have to lower prices to put pressure on the White House.

Tapping Asia's market

THE Saudi determination to drive prices lower is also dictated by another key consideration: the emergence of Asia, and particularly China, Japan and India, as the Middle East's biggest customers.

In theory, the rise of Asia should offer plenty of business opportunities for everyone, as markets for energy products expand. In practice, however, all the oil producing countries - including African producers such as Nigeria, Angola and Algeria - are piling into Asia, since all are terrified by the loss of American markets and are desperate to sign up new delivery contracts.

Yet again, Saudi Arabia leads the way: it slashed its so-called "official selling price" for Asian oil customers, a move which was swiftly followed by a handful of other Opec member states in the Gulf. However, other producers are now daring to go even further: the Iraqi state oil marketing company has just cut its so-called Basrah light crude benchmark price in a bid to win Asian markets.

And Qatar plans to divert more of its light oil and process it in into naphtha and other higher-value products precisely in order to market these in Asia.

The real fight now is not so much about squeezing as much cash as possible out of existing exports but, rather, about making sure that producers gain markets for the future.

The China factor

AND, just as interestingly, after a long period of hesitation, China is now reciprocating the attention by plunging head-on into the Middle East's economies. Overall Chinese trade with Saudi Arabia doubled over the past year alone; trade with Qatar, the small but energy-wealthy Gulf state, quadrupled over the same period.

Qatar is already the main source of China's liquefied natural gas supplies, accounting for 60 per cent of Beijing's requirements. And at the end of a state visit by the Qatari Emir to China last week, Beijing also agreed to make Qatar its Middle-Eastern clearing hub for Chinese yuan currency transactions.

Undoubtedly, the Saudi-led strategy of keeping energy prices relatively low and even depressing them further, is risky. For although the Saudis, Qataris and a few other Gulf producers can withstand the loss of extra cash for a long time, Russia and Iran cannot, and both countries have the capacity of souring Saudi Arabia's strategic environment if they really wanted to.

Furthermore, the Saudi tactic of forcing down US shale oil production by cutting prices may not work because it ignores a tiny detail: American innovation. If US oil drillers continue to improve on the techniques that led them to unlock shale in the first place and lower the break-even prices for production, the entire Saudi gamble against the US falls to pieces.

Still, few doubt the significance of what is currently unfolding. For it was weak oil prices which destroyed the Soviet Union in the 1980s and which fostered the conditions that led to the election of Hugo Chavez as president of Venezuela in 1998; falling oil revenues could this time destabilise not only America's and Saudi Arabia's enemies, but also some of the West's allies.

One conclusion is, however, evident: this tussle for energy prices is an expression of one of the most significant strategic reorientations in years. Precisely a century after colonial Britain and France created the Middle East we know today, Asia is replacing them and the US as the region's biggest market and investor.

Jonathan.eyal@gmail.com