The Political Economy of Oil in the Middle East
March 23, 2017
The early 20th century was a crucial point for the development of the Middle East. Prior to 1950, the region exhibited low levels of socioeconomic development; however, the discovery of vast oil reserves catalyzed the rapid creation of wealth. In particular, the economies of oil-rich countries were transformed from largely agricultural to rentier economies. Rentier economies derive a substantial part of their revenue from the outside world, and the accruing of external revenues (also called rents) are allocated and redistributed.
Since then, modern Arab oil-exporting economies have become heavily dependent on oil. Hydrocarbon and government activities account for the majority of total GDP in nearly every Middle Eastern country. In Libya, for instance, non-oil and non-governmental activities account for just over 0.16% of the GDP. Likewise, oil accounts for 80% of total exports in half of the oil-exporting economies. 
Given this dependence, it’s not surprising that the economies of these oil exporting countries are significantly tied to the price of oil itself. Between 2014 and 2015, caused by a combination of declining global demand and a rapid increase in the production of American shale oil, the price of oil collapsed. from $115/barrel to $50/barrel. 
This piece explores how the dramatic reduction in oil prices affected the economic and political structures within the Middle East. To do so, this piece will analyze the effects of the 2014-2015 reduction in three countries: Saudi Arabia, Iran, and Iraq. In particular, the analysis will explore the pre-2014 economic conditions, how the economies were affected during the period of low oil prices, and what political and economic changes have occurred since.
Saudi Arabia, the world’s largest petroleum exporter and home of 18 percent of the world’s oil reserves, depends greatly on the price of oil.  Its economic, domestic, and foreign policies are all intimately connected with petroleum, and the drastic decrease in the price of oil in 2014-2015 has had significant effects on the country’s domestic policies, as well as the future implications for regional politics and markets.
For decades, Saudi Arabia has been at the center of the global oil market, both as part of the Organization of Petroleum Exporting Countries (OPEC), which sets production targets for each member nation in an attempt to control oil prices, and as a recent paper argued, as an enforcer of the production targets.  Others have argued that Saudi Arabia has played the role of a swing producer, changing its quantity of oil production in order to stabilize the price in response to market changes  Regardless, Saudi Arabia has been a major presence on the world oil market for over 40 years, as shown below: 
Naturally, oil has played a major role in Saudi Arabia’s economy and governmental budget. Oil accounts for 85 percent of Saudi Arabia’s export earnings, as well as about 31 percent of the GDP. Saudi Arabia is clearly economically dependent on oil, and in years past, the government has failed to diversify its economy, as a recent study on Saudi infrastructure spending has shown.  The dependence is compounded by the implicit social contract between the Saudi royal family and the Saudi Arabian citizens. In this system, the government controls nearly the entire economy and employs two-thirds of the workers, providing lavish subsidies and jobs in exchange for an authoritarian political system.  The vast oil wealth of Saudi Arabia allows this social contract to continue as long as oil prices remain high. Furthermore, this wealth allows Saudi Arabia to finance its foreign policy goals; most notably its bid to contain Iranian influence in the Middle East.
The steep fall in the price of oil in 2014-2015, therefore, had a massive impact on Saudi Arabia’s economy and social structure. In contrast to its action in previous periods of oil price drops, Saudi Arabia, along with the rest of OPEC, chose not to cut production in order to increase the oil price. In contrast, it aimed to maximize market share by continuing its production levels in an attempt to force other producers, especially American shale producers, out of the market.  Facing a lengthy period of low oil prices, the Saudi economy struggled. As of 2016, Saudi Arabia’s budget deficit was 13.5 percent of GDP, and oil still accounted for almost 90 percent of government revenues.  The fall in the price of oil has also led to a sharp reduction in Saudi currency reserves and increased government borrowing to make up for the budget shortfalls.
However, the fall in the price of oil has led to substantial changes in Saudi Arabia’s economic plans as well as its foreign policy. Faced with severe budget shortfalls and a weakened economic base, Saudi Arabia’s government has responded by attempting to both reduce government spending and diversify its economy, so far with limited success. These reforms are part of an ambitious plan called Vision 2030. As part of this overhaul, Saudi Arabia hopes to become one of the 15th largest economies in the world, increase the private sector’s contribution from 40 percent to 65 percent of GDP, and raise the share of non-oil exports in non-oil GDP from 16 percent to 50 percent.  Specific plans include floating a small stake in Saudi Aramco, the world’s largest oil company, creating the world’s largest sovereign wealth fund to enable investment in new sectors of the economy, and increasing the role and number of women in the economy.  These plan to be coupled with ways to reduce government spending, including reducing subsidies for gasoline, electricity, and water, and imposing taxes on luxury goods and sugary drinks.  However, there has already been pushback both from conservative clerics, who have disliked the proposal for an increased role for women, as well as from Saudi citizens, who dislike reductions in subsidies and government-provided jobs. 
Saudi Arabia’s foreign policy, meanwhile, has generally involved two main objectives: an alliance with the United States, and a rivalry with Iran. The US-Saudi alliance is largely based on oil, as the US was until recently the world’s largest oil importer.  The rise of US shale oil producers seemed to threaten that alliance, and may do so in the future. Yet several analyses push back against this idea, arguing that Saudi oil dominance will not recede in the near future, and Saudi Arabia will continue to play an important role in the oil markets.  It is also likely that Saudi Arabia never reaches its former dominance, as new rivals such as US shale producers and a newly sanction-free Iran join the oil markets.  It is therefore possible that the US will not be quite so dependent on Saudi oil in the future, and it remains to be seen how that will affect US-Saudi relations.
Within the Middle East, the priority of Saudi foreign policy has been to reduce the power of its rival, Iran.  In contrast to its economic and domestic policy, where the fall in the price of oil has restrained Saudi ambitions and caused large policy changes, Saudi Arabia’s foreign policy has been aggressive over the past few years. With the agreement of the Iranian nuclear deal and the subsequent normalization of diplomatic and economic ties between Iran and the West, Saudi Arabia has continued its efforts to counteract Iranian influence, most notably in Yemen, where it intervened to act against the Shia Houthi rebels, and in Syria, where it has been arming and training Sunni fighters against the Assad regime. Recent analysis suggests that Saudi Arabia has been increasing its efforts and acting more aggressively since the nuclear deal, despite its reduced economic power.  It remains to be seen if economic realities eventually force a re-adjustment of Saudi foreign intervention and engagement.
Iranian foreign policy and economic activity is inextricably tied to oil. Following Saudi Arabia, Iran ranks second globally in natural gas reserves and fourth in proven crude oil reserves . With oil rents making up nearly 20% of GDP in 2014 , Iran is a veritable energy superpower. Government expenditures, therefore, rely heavily on oil prices, which remain volatile to this day .
The United States has played a large role in exploiting Iran’s dependence on oil. Since the 1950s, US foreign policy in Iran has sought to take advantage of Iran’s oil-rich markets. Consider the US backed coup in 1953 that restored the Shah to power, and more importantly, restored oil security for the US . Though US sanctions against Iran have been in place since 1979, new sanctions were introduced with the discovery of Iran’s nuclear program. This program has been extremely costly for the Islamic Republic. In fact, Iranian leaders’ intransigence on the nuclear issue may have cost Iran over $500 billion in lost oil revenues due to sanctions, cost of construction, research, and operation .
In 2014, Iran’s economy made a turnaround from the recession that was in part triggered by US sanctions. GDP growth was 4.3% that year. With plummeting oil prices, however, Iran’s economy has taken a major hit. GDP growth in 2015 dropped to 0.4% . The landmark Iranian nuclear deal in 2015 produced less of an economic boost than was predicted, since jobs were scarce and foreign investors were still wary. The oil market, however, was full of promises . Production in 2015 soared to 3.8 million barrels a day 6 months after sanctions were lifted. The figure below shows Iranian oil production during the period of US sanctions .
Like many oil-rich states, Iran’s subsidy program is robust. Prior to the Iran deal, it cost an unsustainable $40-100 billion per year in energy, fuel, water, and food . By 2009, the country was the largest provider of fuel subsidies in the world . In 2010, President Ahmadinejad enacted a reform plan that would cut $20 billion in subsidies . Ahmadinejad also took advantage of the high oil prices to enact universal monthly cash transfers (about $12). With falling oil prices, Iran can no longer sustain such a program . The oil plunge has hit the country hard. In order for Iran to balance its budget and avoid deficit, barrel prices need to be above $100 . With crude oil prices at around $50, the national economy is taking quite the hit. Putting economy aside, Iranian foreign policy for the past decade has largely been dictated by its reliance on oil. With oil prices dropping, Iran is losing leverage in diplomatic negotiations with the United States. Any violations of the Iran deal will result in sanctions–ones that Iran cannot afford.
In early September 1960, the Iraqi government hosted officials from Venezuela and three Gulf Countries –Iran, Kuwait, and Saudi Arabia– for a five-day conference in Baghdad. Responding to a decrease in the posted prices by international oil companies, the five countries founded OPEC.  In the decades since, Iraq has helped to lead OPEC as membership and output have expanded. Given this intimate link between the price of oil and Iraq’s domestic institutions, the decrease in oil prices in 2014-2015 had a severe political and economic impact.
Iraq’s oil production was nationalized in 1972. Shortly thereafter, in 1979, oil production reached its peak at 3.5 million barrels per day (mbd).  The outbreak of war with Iran in 1980 depleted Iraq’s foreign exchange reserves and left the country saddled with more than $40 billion in debt.  Subsequently, Iraqi oil took an additional hit when, under the regime of Saddam Hussein, the leader had decided to invade another founding member–Kuwait. Despite having the third largest reserves of oil, Iraq dropped to 13th place in the international oil production table. 
Since then, Iraq has tried to revamp oil production to pre-Gulf War levels. In 2014, Iraqi oil production averaged at 3.4 mbd. This production growth accounted for nearly 60% of the production growth among OPEC countries.  Oil revenues accounted for 47% of Iraq’s total GDP and 95% of Iraqi government revenue. Similarly, oil exports accounted for more than 90% of total exports.  More importantly, 2014 also marked the beginning of the Islamic State of Iraq and the Levant (ISIL) offensive within Iraq. ISIL was successfully attacking northern Iraqi oil facilities, reducing both production and refinery operations. However, 95% of Iraq’s total oil output is accounted by the southern oil facilities, which are clustered away from the conflict.  Therefore, the Iraqi government was able to increase production and output levels despite the heightened security threat. The chart below documents Iraqi oil production over these past several decades. 
Given the enormous dependence on oil, the drastic drop in its price had severe effects on Iraq’s economy. Particularly, unlike other countries, Iraq faced a double-shock. The first shock was a decline in the price of oil. Basic economics tells us that a drop in price without a comparable increase in sales (or exports, in this case) will reduce revenue. Indeed, though Iraq experienced relatively stable export levels, as a result of falling prices, 2015 oil revenues decreased by nearly $35 billion compared to 2014. 
The second shock was the ISIL insurgency within northern Iraq. The costs of fighting the Islamic State put enormous fiscal pressure on the Iraqi government. High security spending rapidly widened the budget deficit, which reached 13.5% of GDP in 2015. Similarly, whereas in 2014, the current accounts balance was a surplus of 2.7% of GDP, in 2015, the balance was a deficit of 6.1% of GDP.  Greater military spending further forced the Iraqi government to divert resources away from investment within oil infrastructure, further exacerbating an already difficult economic situation.
The fall in oil prices was in many ways a painful awakening for how Iraq has conducted its economic affairs. Prior to the drop in prices, oil profits fed a corrupt political system based on patronage. Rather than invest in public services, the money fed “an unsustainable expansion of government payrolls, and with it, a rise in consumer spending.”  Long-term economic recovery, then, will require economic diversification and structural reforms.
Within this context, the IMF approved Staff-Monitored Program (SMP) in 2015, which focused on implementing economic and financial policies to help the country cope with its current economic condition. As the name suggests, an SMP is an informal agreement between a country’s relevant governmental or economic authorities and IMF staff to monitor implementation of the authorities’ economic program. Under the SMP, authorities will implement fiscal consolidation that will contain public expenditure in line with available revenue and financing. The SMP will also aim to reduce the non-oil primary deficit by $20 billion, or 12% of non-oil GDP. The SMP will further take efforts to strengthen public financial management, anti-money laundering campaigns, and countering the financing of terrorism.  In July, 2016, the IMF approved a $5.34 billion loan to support and build upon this arrangement. 
Driven in part by a projected ramp-up in oil production as well as the implementation of the IMF program, the Iraqi economy is projected to grow at 7.2% in 2016 and hover around 5% for the next few years . Despite these projections, the relatively low oil price and the continued ISIL insurgency place the macroeconomic output at significant risk.
The recent decline in oil prices has had a variety of extremely impactful effects on major oil-producing countries, most notably Saudi Arabia, Iraq, and Iran. All three countries are heavily dependent on oil exports and production, and the fall in prices has caused very difficult economic situations for the governments and citizens of these three nations. Yet each also faces unique challenges which further complicate the domestic and regional situation. In Saudi Arabia, the fall in the prices of oil has complicated both the social contract of lavish perks, jobs, and subsidies in exchange for an authoritarian political system as well as an active, anti-Iranian foreign policy, causing far more damage than simply lower economic growth. In Iran, US sanctions and the nuclear deal have led to fluctuating production and further challenges as Iran attempts to rejoin world markets while suffering from a variety of internal and external economic pressures. Finally, in Iraq, the fight against ISIL has brought severe damages, including economic calamity. The fall in oil prices has both intensified these pressures on all three countries as well as causing economic hardship of its own, and ultimately local, regional, and international affairs will be greatly impacted by the way these three countries respond to these pressures.
Additional Blog Posts
Student Blog Disclaimer
The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Wharton Public Policy Initiative’s strategies, recommendations, or opinions.