Alberta and oil prices: How Middle East geopolitics and religion affect our future

First published March 27.

Calgary is unlike most other cities.

It is a city of 1.2 million people separated from its two nearest urban neighbours by 300 kilometres of prairie and 1,000 kilometresof mountains.

Yetas a cityCalgary's economic fortunes are affected less by the surrounding landscapes and neighbouring cities, and more by difficult-to-comprehend and impossible-to-influence decisions made on the other side of the planet.

• ANALYSIS |Oil optimism yes, but it's too early to bet the farm on a full-fledged recovery: Don Pittis

For better or for worse Calgary's well-being and prospects hinge on the world price of oil.

Here is a look at the escalating rivalry between Iran and Saudi Arabia and what its impact might be on Calgary.

The history of the rivalry

We have visited and worked in both countries.

To Albertaeyes there are many similarities between the two Middle Eastern countries ruled by adherents of Islam.

But that only makes the rivalry more difficult to understand.

So, what are the differences between the two countries? What is the historical basis of this national rivalry?

Why is it heightened today?

• Saudi Arabia severs ties with Iran, expels Iranian diplomats
• Justin Trudeau advised to deepen ties with Saudi Arabia, brace for change in Iran

And does all this have any implications for Calgary's economic fortunes as a city tied in to the global oil market?

The Kingdom of Saudi Arabia and the Islamic Republic of Iran are the largest and most powerful countries in the Middle East.

Ethnically Saudi Arabia is Arab while Iran is predominantly Persian.

Saudis speak Arabic, while Iranians speak Farsi.

While both are Islamic states, Saudi Arabia follows the dominant Sunni Islam while Iran follows the minority Shia Islam.

Shia Islam, practiced by only 10 per centof Muslims worldwide, traces its origins to the death of the Prophet Muhammad when Shiites claim that spiritual leadership was passed to twelve of his descendants.

Sunnis do not. The two branches of Islam have been rivals ever since.

• Sunni, Shia conflict rooted in dispute over Prophet's successor

This sectarian divide forms the basis of most of the conflicts in the region.

Iran tries to expand its sphere of influence through its Shia co-religionists in the region while Saudi Arabia does the same with its Sunni allies.

But what does it have to do with Calgary and the global oil economy?

Iran and Saudi Arabia can produce low cost oil

In 2014 this ancient animosity between these two regional powers spilled over into the global oil economy.

Saudi Arabia and Iran are two countries with some of the largest onshore oil reserves that can be produced at low cost. Oil exports provide significant revenues to both governments.

Saudi Arabia is the world's leading exporter of crude oil.

While Saudi has used oil revenues to build its financial strength, Iran has been excluded from the global oil market since the United States and others imposed economic sanctions on Iran, originally in 1979 and strengthened in 1995.

Recent multi-lateral negotiations resulted in the removal of these sanctions in exchange for Iran limiting its nuclear programs and subjecting them to international scrutiny.

In January 2016 agreement was reached and sanctions have been lifted. Iran may now resume selling its oil on world markets and may invite new international investment in its oil industry.

• Canada lifting some economic sanctions against Iran to 'resume dialogue'

This re-entry of Iran into the global oil market comes at an inopportune time.

The world already is awash in oil.

So who is going to make room at the oil market table for the newly arrived Iranian guest?

• Oil slides below $30 US as Iraq ramps up production

Will Calgary and Alberta let the Iranians take our market share? Will Saudi and other Middle Eastern producers cut back their production?

Probably not and the surplus supply of oil will continue to depress world oil prices.

How Calgary got rich

Why is the world awash in oil? Or to put it another way, why are there so many guests crowding around the world's oil market table?

In the last decadeandahalf growing energy demand from China, India and the other emerging economies coincided with declining production from conventionaloil reserves.

Markets became concerned that new oil supplies were increasingly difficult to find and develop. In a market short on supply while facing huge demand, oil traders drove prices above $100 per barrel.

• $100 oil: Will we ever see it again?

High prices encouraged innovation in Canadian oilsands technology and production surged ahead.

Equally, new horizontal drilling and hydraulic fracturing technology developments brought unprecedented quantities of new U.S.and Canadian shale oil and natural gas onto the global market. Alberta and the Calgary economy boomed, again.

At first this new North American shale oil and oilsands production did not affect global oil prices because the growing Asian economies absorbed these new barrels.

When demand from Asia started to slow, the Organization of Petroleum Exporting Countries (OPEC), led by Saudi Arabia, cut supply to support the global oil price.

Then things go wrong

OPEC has actively managed oil prices since the early 1970s by coordinating production and controlling the global supply. Alberta is a significant oil exporter and has benefited from OPEC's global oil price management

But recent increases in oil supply came from Alberta oilsands and North American shale oil, not from the OPEC countries.

Their strategy is to discipline the producing countriesHarrieVredenburg, Tim Marchant

World markets looked to OPEC to limit its production to make room for these new oil barrels.

In late 2014 OPEC decided that it would no longer restrict its production to compensate for the new production from North America.

• Oil price predicted to fall to $60 unless OPEC cuts back

OPEC and the Saudis were losing too much of the global market share.

The Saudis and the rest of OPEC were free to produce as much oil as they wanted.

The result was a dramatic 70 per centdrop in oil prices which caused devastation to Calgary-based oil producers.

Why did Saudi Arabia take this damaging decision?

Their strategy is to discipline the producing countries and cause high cost oil producers to exit the market.

The assumption is that in time the U.S. shale oil producers, the Alberta oilsands producers, and deep water offshore producers, like Brazil, will be forced out of the market due to their high production costs.

It is doubtful that the Iranians figured much in this Saudi calculation as the Iranians had been sidelined by sanctions for years and negotiations to remove sanctions did not look to be progressing. And when running steady-state, Iranian production is not high-cost.

In time Saudi Arabia would be the last one left standing as it boasts some of the lowest oil production costs in the world and, unlike some other OPEC members, it has significant financial reserves to see it through a resulting price war.

Alberta cuts costs

The resultant supply war has now been more protracted than most people expected. The high-costproducers have not yet exited the market because they had already made their big capital investments during the high oil price years.

Alberta oilsands producers with plants built or capital committed have ground their costs down and continue to produce.

Shale oil producers have done the same and have taken only marginal assets out of production, maintaining much of their production.

But some North American production has declined and the pace of this decline appears to be accelerating. And companies have stopped making new oil production investments.

Even the decision makers in Saudi Arabia are now having second thoughts.

• Russia, Saudis offer oil output freeze, but oil sells off anyway

Recent discussions between OPEC and non-OPEC producers such as Russia have tentatively agreed to freezeoil production at current levels to support the global price.

But not the Iranians!

Having just come out of sanctions, Iranians argue that they will not freeze or cut production until they regain their historic global market share. It may take them some time to crank up their oil industry given the lack of new investment for many years.

The long-standing rivalry between these two countries suggests that the Iranians are unlikely to cooperate with the Saudis.

And the Saudis are unlikely to be willing to give up some of their market share to the Iranians.

Alberta is caught in the middle

Is there anything that Alberta can do about oil prices?

In a global free market for a commodity like oil there is little a producer can do except be a 'price taker' of global prices.

Given that the two most important Middle Eastern players in the global oil market are unlikely to cooperate, the Canadian oil industry is reshaping itself to survive a period of sustained lower prices.

Alberta producers will need to innovate to ensure that they have low costs of production in order to survive and thrive in a lower priced world market.

It will take time, but history tells us that periods of low prices have led to innovation and reinvention in Canada's oil industry.

And low oil prices, almost by definition, beget higher oil prices. We are confident that a new, stronger industry will emerge to once again power the Calgary economy.

The authors of this story:

Dr Harrie Vredenburgis founder/Academic Director of the Global Energy Executive MBA, Professor and Suncor Energy Chair in Strategy and Sustainability at the University of Calgary's Haskayne School of Business. He is alsoInternational Research Fellow at Oxford University.

Dr Tim Marchant is Adjunct Professor-Strategy and Geopolitics with the Global Energy Executive MBA at the University of Calgary's Haskayne School of Business. He worked for 30 years in the oil industry including 10 asan executive in the Middle East.

Calgary at a Crossroads is CBC Calgary's special focus on life in our city during the downturn. A look at Calgary's culture, identity and what it means to be Calgarian. Read more stories from the series at Calgary at a Crossroads.