Oil kingdom 'in chaos' unnerves markets and threatens health of global economy

High prices and terrorist threat in Saudi Arabia prompt fears about disruption to supplies

The rupture in US-Saudi oil relations over the last three years has left the markets wondering: what if production from the Kingdom was disrupted or taken out altogether?

Although the Saudis provided a helpful statement yesterday, saying they would push Opec to raise production, the fact is that the country's regime has been willing to tolerate much higher oil prices in recent times ­ even in a US election year. That has been a major breach with past policy and it has left Opec's official target range of the oil price ­ of $22 to $28 a barrel ­ looking irrelevant.

Saudi Arabia is the leader of Opec, it is the world's biggest producer and it is sitting on a quarter of the globe's oil reserves. It is no exaggeration to say that, given the importance of oil, the health of the global economy rests on the maintenance of supplies from this despotic Middle Eastern kingdom.

Leaving aside Saudi Arabia's shift in policy, more worrying still for the West is the prospect that terrorist attacks on Saudi soil ­ which we have seen directly target oil facilities ­ or a change of government could seriously dent the country's output.

Mai Yamani, an expert on Saudi Arabia at the Royal Institute of International Affairs, says that political tension, rising violence and division among the princes of the ruling House of Saud, means that the country is in "chaos".

"Certainly the violence is going to increase.... It is the beginning of the end [for the regime]," Dr Yamani says.

There is little in the way of a liberal opposition to the authoritarian Saud regime, leaving the extremists the likely successors if the government did fall. However, analysts are united in believing that any regime in Saudi Arabia would need to export oil.

Valerie Marcel, also of the Royal Institute of International Affairs, says: "There is very little chance of a new regime that would not sell the oil. What else would it survive on? Ninety per cent of government revenues come from oil exports."

Although Dr Marcel gives a much higher chance of survival to the House of Saud, she says the Government must overcome major obstacles. "Saudi Arabia is facing some very serious challenges in the next 10 years. The population will double by 2020. Many more jobs have to be created, the economy must be diversified," she said.

With Iraq in turmoil, and big political troubles in Nigeria and Venezuela, two other major producers, the markets have been spooked by the possibility ­ however remote ­ of a further destabilisation of Saudi Arabia.

Analysts point out that markets are driven by perception, as well as reality. So an avowedly anti-Western regime in Saudi Arabia, even if it continued to export similar levels of oil, would be likely to add a risk premium to the price of oil. And there may be relatively small changes in the supply of oil from Saudi Arabia that can often cause huge swings in the price.

Jamal Qureshi, of PFC Energy, a US consultancy, points out: "So much of the [oil] market trades at the margin. It's the amount of cushion that makes an impact."

A Saudi government unsympathetic to US and other Western interests, could, for instance, stop the current practice of supplying the US at a discounted rate or not take on the current role of Saudi Arabia as the "swing producer" that maintains spare production capacity to plug any shortage in supply.

There has been a break in US-Saudi relations, particularly since the 9/11 terrorist attacks led Americans to question how close it should be to the Kingdom ­ some even see this as the real reason for the American invasion of Iraq.

For its part, the Kingdom has seen that serving US interests threatens its position at home with its own population and its anti-Western clerical establishment. Furthermore, unlike in the past, the Saudi Government needs oil cash to shore up its strained finances.

Compared with the 1970s, which produced two "oil shocks", the amount of world oil that Opec produces has reduced from more than 50 per cent to less than 40 per cent now, as production from countries outside the cartel has risen. And we should remember that, in real terms, $40 oil today means a much lower price than it did in the 1970s.

However, the enduring power of Opec has been shown in the last three years by its ability to successfully keep the price of oil high. Although Opec is currently producing some 28 million barrels a day, of total world output of some 80 million barrels, only the cartel has spare capacity.

Opec could pump out another 3 million barrels a day ­ of which Saudi Arabia could provide 2 million extra barrels. As well as the geopolitical fears, a tight fundamental supply-demand situation has seen a high price maintained in recent times ­ culminating with the oil price hitting a 13-year high of $40 a barrel last week.

So if increased output is required to moderate the high price of oil, it is Opec and, most importantly, Saudi Arabia, that must provide it.

Saudi Arabia's intervention yesterday, calling for Opec to raise output by 1.5 million barrels a day, shows that even it has become concerned about the threat to global growth from high oil prices ­ lower growth would mean lower oil demand.

Rising oil prices have a triple-barrelled impact on the economy. Their immediate impact is to cut consumers' disposable income, as rising petrol and energy costs leave them less cash in their pockets to spend on goods and services. At the same time, many of those businesses that are hit by a fall in demand are also pummelled by a surge in their raw material costs.

Lastly, rising oil prices push up inflation as businesses raise their prices and workers demand higher wages to offset their sagging incomes, forcing central banks to raise interest rates.

Andrew Oswald, a professor of economics at the University of Warwick, said the West had become too complacent about the role of oil prices in booms and busts. He believes he was proved correct when the collapse in oil prices coincided with an economic boom in the US in the 1990s that ­ mysteriously ­ came to a halt as oil prices tripled within the space of three years.

He dismisses arguments that oil no longer matters because of the fall in the amount of economic wealth now spent on oil. "That's not a sensible argument," he says. "You should remember that the modern world runs by moving things and people and that 95 per cent of everything that moves, moves because of petroleum."

He said the arrival of China as a global economic powerhouse would force analysts to revise their forecasts. Professor Oswald said a country four times the size of the US was using just a quarter of the amount of oil. "As China becomes as industrialised as the US, none of the oil arithmetic will add up any more," he said.

Raghuram Rajan, an economic counsellor at the IMF, said last month that every extra $5 on a barrel of oil would cut world growth by about 0.3 per cent. "It is worrisome that supply conditions are not slack enough, especially if one major producer is withdrawn perhaps because of geopolitical conditions," he said.

Oil prices have jumped from $30 to £40 a barrel in just five months, almost perfectly tracking the build-up of armed resistance to the American presence in Iraq. "Oil prices at $50 would tip us into a world recession ­ not a 1970s style recession which was the worst for 100 years ­ but certainly serious," warns Professor Oswald.

The oil arithmetic, and with it the success of the global economy, rests on Saudi Arabia. That is an awful lot to rest on the continuation of a brutal regime that is under increasing threat from its own people and that has lost its key alliance with the United States.