Wharton's Howard Pack and Georgetown's Brenda Shaffer discuss the Saudi Arabia-Iran conflict

The New Year has begun with alarm bells ringing across the globe over the potential economic impact of the ongoing conflict between Saudi Arabia and Iran that has now expanded to include other countries in the region. In the foreseeable future, the conflict is unlikely to impact oil prices much with supply outstripping demand, according to experts at Wharton and Georgetown University. Indeed, oil prices hit an 11-year low on Wednesday.

Investment flows into Arab states are also a non-issue with minimal FDI going into Arab states over the years, except into natural resources facilities, the experts said.

The immediate trigger for Saudi Arabia breaking ties with Iran was last weekend’s attack by a Shiite Iranian mob on the Saudi embassy in Tehran. That was in response to Sunni-dominant Saudi Arabia on Saturday executing Sheikh Nimr al-Nimr, a prominent Shia cleric and activist, along with 46 others. Saudi Arabia also did not relish it when U.S. Secretary of State John Kerry on Thursday praised Iran for taking a “significant step” in shipping low-enriched uranium to Russia as part of fulfilling conditions to allow six world powers including the U.S., the U.K. and Germany to lift sanctions against it.

Geopolitical events tend to have a direct impact on oil prices in a tight market when demand and supply run close to each other, said Brenda Shaffer, a professor at Georgetown University’s Center for Eurasian, Russian and East European Studies (CERES). “When we have a liquid market, like we have now, where there is a huge gap between supply and demand, then geopolitical events, unless they affect the physical supply of oil, don’t tend to have more than a hiccup on oil prices,” she explained. Shaffer is also a senior fellow at the Global Energy Center at the Atlantic Council, a Washington, D.C.-based organization focused on promoting global security.

“The impact in terms of investment flows [into Arab countries] is minimal because they have basically been nonexistent,” added Howard Pack, Wharton professor emeritus of business economics and public policy. The Arab countries have been “remarkably small recipients of foreign direct investment,” he noted. Singapore, which has 3.5 million people, receives more FDI every year than all the Arab countries put together, he said. “The flows have gone out of the Middle East — somebody will buy the Harrods store in London, but there is precious little investment going into the Middle East, excluding the natural resources sectors.” (Egyptian businessman Mohamed Al-Fayed bought Harrods in 1985, and sold it in 2010 to Qatar’s sovereign fund.)

“When we have a liquid market, like we have now … geopolitical events, unless they affect the physical supply of oil, don’t tend to have more than a hiccup on oil prices.”–Brenda Shaffer

Shaffer and Pack discussed the economic impact of the conflict, its underlying causes and the role the U.S. could play in de-escalating the tension on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Diminished Role of Oil and OPEC

According to Shaffer, the Organization of the Petroleum Exporting Countries (OPEC) also would be unable to impact oil prices in the current scenario. She dismissed speculation in the international media that the conflict would prevent cooperation on a production cut within OPEC, which includes Iran and Saudi Arabia among its 13 members. “We have not adjusted to the fact that OPEC isn’t OPEC [any longer],” she said. In its heyday in the 1970s, OPEC countries accounted for 60% of world oil production, but that has since fallen to 40%. Pack added that OPEC has much less power today compared to earlier times, “given all the alternative sources of energy including U.S. fracked oil, which is significant.”

“It is not that OPEC has decided not to cut back. It really can’t cut back,” Shaffer said. “What could they do? Cut back and let everyone else enjoy the higher prices? It is not an option.” Saudi Arabia, in particular, would have no incentive for a production cut, she added. “It was unimaginable that Saudi Arabia would cut back production in order to jack up prices, so that as Iranian oil comes in, Iran can benefit from it.

“Today, we might have more people on the planet and … in absolute volumes we consume more oil than we did in the 1970s, but oil’s relative place in our total fuel consumption has gone down significantly,” added Shaffer. In the 1970s, oil represented more than half of all the energy consumed, including gas, coal, nuclear and renewable sources, but its share has fallen to 34%, she noted.

Pack agreed with Shaffer that the implications of the conflict on oil prices are not overly significant. He said that while the marginal cost of extracting oil in Saudi Arabia is between $3 and $4 a barrel, political considerations have always dictated prices. “OPEC acted, as long as it could, as a cartel to keep oil prices up. That cartel is now clearly broken,” he said. “With the addition of fracking, especially from the U.S., it is not clear what the bottom is for oil prices. There is no way of modeling this because we know that the bottom price could be as low as $4 to $5 a barrel.”

“OPEC acted, as long as it could, as a cartel to keep oil prices up. That cartel is now clearly broken.”–Howard Pack

Seeds of Conflict

Shaffer read the Saudi Arabia-Iran conflict as not so much about Shia vs. Sunni interests but more about two powers that are neighbors but have different strategic orientations. While Saudi Arabia is aligned towards the U.S., Iran is against the status quo and is a rising power in the Middle East, she said. “If we take the ideological framework out of it, it is a lot easier to understand what they are doing and why they are doing it.”

According to Shaffer, “Iran has both the geopolitical and oil interests to bring this instability into the domestic arena in Saudi Arabia.” She noted that Iran has been stoking trouble in the region for a while now by activating Shiite populations, fighting a proxy war against Saudi Arabia inside Yemen and launching cyber attacks on Saudi Arabia’s national oil company, Saudi Aramco. “Such actions cannot affect the long term price structure of oil, but it could set it up for a spike at a time when Iranian oil is returning to the market,” she said.

In addition to those provocations, Saudi Arabia also feels “very vulnerable” with Iran “arming itself to its teeth,” said Pack. They also feel abandoned by the Western powers, he added. “The reason for the immediate conflict is the Saudis are upset at the Iranians being given the green light by the U.S. to both go ahead with nuclear development and ICBM (inter-continental ballistic missiles) launchings, which the Obama Administration … is treating as a non-event.” Last October, Iran successfully test-fired its Emad medium-range ballistic missiles, three months after it signed an agreement with the five U.N. Security Council members and Germany to curtail its nuclear ambitions.

Another contributory factor is the pressures caused by China’s economic slowdown, said Pack. He also cited the consequent commodity price crash that has hurt Brazil and several African countries that are commodities exporters. “[The] absence of demand from China … combined with very slow growth in Western European countries, and not-very-robust growth in the U.S., is a recipe for economic hardship in many parts of the world. This is not going to be easy to rectify.”

The Role of World Powers

What roles do world powers have in helping resolve the Saudi Arabia-Iran conflict? According to Shaffer, Europe is important in terms of investment and economic programs, but not in military strength. “We’ve seen in Europe that they cannot manage their own border security,” she said. “I don’t see them having much impact on security issues in the Middle East.”

Pack noted that European nations have only recently begun devoting between 1% and 2% of their GNP on defense, compared to about 4% by the U.S. He recalled the U.S. policy to “follow from behind” in the overthrow of Muammar Gaddafi’s dictatorship in Libya in 2011. “France and other countries did not have a force to deal with what was basically a Bronx street gang,” he said. “So they had to call in reinforcements with the U.S. leading from behind.” In resolving the Middle East crisis, “the Europeans are totally irrelevant.”

“If we take the ideological framework out of it, it is a lot easier to understand what they are doing and why they are doing it.”–Brenda Shaffer

Shaffer saw little room for hope also in Turkish Prime Minister Ahmet Davutoglu’s offer to help resolve the conflict peacefully. “I don’t think [Turkey can help resolve the conflict] between Saudi Arabia and Iran under current conditions when there is no adult in the playground in the Middle East, no clear lines in terms of security and deterrence,” she said. “They can maybe tone it down.”

After that elimination round, the focus shifted to the U.S. “The U.S. could stop it, but under a Kerry-Obama administration with a very weak National Security Administration, the U.S. is not going to do this,” said Pack. He suggested that the U.S. could talk tough with Iran over its ICBM program and threaten to hold up the funds it stands to recover from oil sales after sanctions are lifted. Estimates of that total ranges from about $50 billion, according to U.S. Treasury Secretary Jack Lew, as the Washington Post reported, and $150 billion according to critics of the Iran deal.

Added Shaffer, “In a sense, the [Obama] Administration over-learned the lesson of the U.S. presence in Iraq and Afghanistan and its lack of ability to achieve goals there. On the one hand, when you try to use military force to do things like state-building and change society, it just doesn’t work. On the other hand, failed states are extremely dangerous.”