As the turmoil in the Middle East spreads to Libya, a major oil producer, the shockwaves of Arab unrest are reverberating through the global oil supply chain – and threatening to spill over into the global economy.
With portions of Libyan production shut down by armed clashes across the country between opponents of Moammar Gadhafi's four-decade regime and his supporters, global oil prices rose above $110 Wednesday, based on the widely used Brent crude benchmark.
In the U.S., the surge in crude prices is expected to flow quickly to the cost of gasoline, further straining budgets stretched tight by sluggish wage gains.
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Higher prices, not just for energy but for food too, are a problem because food and energy are nondiscretionary, said Howard Ward, chief investment officer at GAMCO Growth Fund. “And they're now poised to take a bigger share of wages than we've seen in several years. That will have a dampening impact on discretionary spending. We still have an economy that is 70 percent consumer spending.”
Gasoline prices averaged $3.19 last week a gallon, up 57 cents from a year ago. (Economists estimate that every additional $1 rise in the price of oil adds about 2.5 cents to the price of gasoline.)
The impact of higher gasoline prices on the economy could be felt quickly. Chris Lafakis, an economist at Moody's Analytics, figures that if oil prices average $103 a barrel in 2010 (up from $80 last year), that would wipe about roughly half of the $120 billion payroll tax cut that’s helping to boost the U.S. economic recovery. At $120 a barrel, that stimulus impact would be erased.
Even if prices stabilize at roughly $100 a barrel, the higher cost of energy comes as the global economy is already struggling to keep up with rising food prices.
“Continuing that level of price is very, very bad to the global economy, especially to the emerging economies like India, China, Africa," Nobuo Tanaka, the Executive Director of the International Energy Agency, told CNBC on Tuesday. “So they have a much more serious problem.”
Until recently, the turmoil in the Middle East appeared to pose limited risk to global oil supplies. Neither Tunisia nor Egypt produce oil or gas. Now, even as Libya devolves into civil war, its oil output makes up a relatively small portion of total global supply.
But strong demand from a booming global economy has squeezed most of the slack from world production. Oil prices are surging on fears that any further outages could stretch the oil supply chain to the limit.
As aging Arab regimes fall and new governments emerge, it’s unlikely those countries with oil reserves would withhold supply from the market as a matter of policy; any new government would badly need those oil revenues.
The bigger threat is that a new government would be unable to maintain production. In 2002, after a general strike in Venezuela, Hugo Chavez fired 19,000 employees of the state owned oil company and replaced them with workers loyal to his government.
Eight years later, Venezuelan oil production still lags pre-strike levels. In Iraq, oil production fell sharply after the U.S. invasion in 2003. Despite heavy capital investment and technical assistance, it took five years to restore Iraqi oil output to pre-invasion levels.
Following a dip in consumption during the global recession of 2006, global demand for oil has bounced back to about 88 million barrels per day, just barely ahead of current production levels.
On the supply side, Saudi Arabia is the only major producer with significant surplus capacity. Together with a handful of other Gulf producers, OPEC has an estimated 4.7 million barrels a day of surplus capacity, according to the Energy Information Administration. (A portion of that surplus is so-called “heavy” crude, which some refineries are not set up to handle.)
Amid the threat of outages, Saudi Arabian officials have expressed confidence that any lost output elsewhere in the Middle East can be made up for with increased Saudi production.
"The market knows that Saudi has a good, chunky excess capacity and a record of using it when needed," deputy oil minister Prince Abdulaziz bin Salman Al Saud told CNBC Tuesday.
But that excess capacity has never come under the kind of pressure posed by the widening unrest in the richest oil producing region in the world. Even before the uprisings began three weeks ago, there was very little slack in the global oil supply chain.
As of Wednesday, roughly a quarter of Libya’s output of 1.8 million barrels a day was shut in; a full shutdown would leave a little less than three million barrels of excess capacity. That cushion could be more than overtaken if production is crimped by unrest and uprisings in Yemen, Algeria, and Iran – which together produce more than five million barrels a day.
Oil production slowdowns could also be offset by strategic reserves held by a handful of western countries. Those reserves are estimated at around 1.6 billion barrels, about half of which are held in the U.S. But the use of those reserves to tamp down oil price spikes has had only mixed success in the past.
The biggest threat comes from the potential spread of turmoil to Saudi Arabia, the lynchpin of global oil production. The Saudi regime shares many of the conditions that have sparked uprisings in neighboring governments: rising food prices, autocratic rule, a large population of disenfranchised young people, and ethnic and religious divisions. Until recently, many western observers felt the risk of unrest there was limited by the Saudi government’s ability to use its oil wealth to calm restive groups seeking its demise.
On Wednesday, Saudi King Abdullah returned home after a three-month absence for back surgery to announce a $37 billion program to help lower- and middle-income citizens. The plan announced by the 87-year-old king includes pay raises, unemployment benefits and affordable family housing.
King Abdullah’s age and health have raised further questions among analysts about the stability of the regime and the kingdom’s succession plan at a politically volatile moment. (During his absence, Abdullah’s ailing octogenarian half-brother, Crown Prince Sultan, was left in charge.) Now, some analysts are wondering whether the recent multi-billion-dollar payout will be enough to insulate the world's top oil exporter from the ongoing wave of Arab uprisings.
“We have a very difficult time looking at a map of recent unrest and finding reasons to persuade ourselves that Saudi Arabia will somehow find a way to be an oasis in the middle of this particular sandstorm,” Peter Beutel, president of Cameron Hanover, an energy consulting firm, wrote to clients Wednesday. “We are not saying it is going to happen, but we are having a very hard time finding convincing reasons why it won’t.”