Oil Prices and the Ukrainian War

On March 8, 2022 US President Joe Biden imposed a ban on imports of Russian oil, gas, and energy . Said the US President: “This is a step we’re taking to inflict further pain on Putin.” Biden also said that Americans may have to deal with the economic repercussions of this tough decision for sometime. Gas prices in the US had touched well over $4/gallon, which was higher than the previous record set in 2008, before the announcement. 


Over the past few days, the US has been looking for alternatives to Russian oil. Last week, a delegation of US officials visited Venezuela, and apart from the release of detained US citizens in Venezuela, the removal of sanctions was also discussed (as a goodwill gesture, two prisoners were released on Tuesday, March 8, 2022). The US delegation also met with President Nicolas Maduro.

In the Middle East, the US and other countries are looking to Saudi Arabia, the UAE, and Iran for making up for the shortfall caused by the sanctions on Russia. Iran, which currently pumps over 2 million barrels per day (bpd), could raise this number significantly to 3.8 million. This would reduce global oil prices and the pressure on countries dependent on oil imports. During his address, last month, to the Gas Exporting Countries Forum (GECF) held at Doha (Qatar), Iranian President Raisi had said that Iran was willing to fulfil the energy needs of countries, including European nations.

The Biden Administration’s decision to look at alternatives for oil supplies has drawn stinging criticism. A Republican policy maker, while commenting on this decision, said:

The decision to explore alternative sources of oil and gas has fit would be outrageous to even consider buying oil from Iran or Venezuela. It’s preposterous that the Biden administration is even considering reviving the Iran Nuclear Deal.

It would be important to point out that while Iran may be an important option for the US and other countries, this would only be possible if the Iran Nuclear deal 2015 is revived, and sanctions are removed. Russia has created a major hurdle by asking for a written guarantee from the US that sanctions imposed by it will not apply to Russia’s economic linkages with Iran. The US has dismissed Russian demands and said that the sanctions imposed are not linked to the Iran deal. Apart from this, there are sections of US policy makers vehemently opposed to the deal. 

If one were to look at the case of the UAE and Saudi Arabia, both countries have refused to take the calls of President Biden – the two Gulf countries have turned down US demands to pump more oil. Both countries also took time to vote for the UNGA resolution against Russia’s invasion of Ukraine (in recent years there economic and defense ties with Russia have improved). It is important to understand that ties between Washington and both the Gulf nations have soured for a number of reasons.

Reasons for deterioration in Saudi-US ties 

If one were to look at the instance of Saudi Arabia, Washington’s ties with Riyadh have gone down hill due to a number of issues including two big ones: Washington’s withdrawal of support to the Saudi Arabian war offensive in Yemen, and strained ties between Biden and Crown Prince Muhammad Bin Salman (MBS). Biden, unlike Trump, has refused to deal with MBS and has been speaking to MBS’ father (King Salman) instead. One of the major bones of contention has been the release of an unclassified report in 2021, which clearly points to the role of MBS in the brutal murder of Saudi journalist Jamal Khashoggi (Trump had refused to release this report). Visa restrictions were imposed on 76 Saudi citizens involved in harassing journalists and activists by the Biden Administration, but no such measures were announced against MBS.

During his presidential campaign, Biden had been stinging in his criticism of Saudi Arabia’s human rights record and vowed to treat Saudi Arabia as a “pariah,” and the decision of the Biden Administration not to sanction MBS directly drew strong criticism from certain quarters within the Democrats. Saudi Arabia’s growing proximity towards China has also been a bone of contention in US-Saudi relations. In December 2021, US intelligence agencies suspected that China was assisting Saudi Arabia with the development of its ballistic missiles program. In a recent magazine interview, MBS said that he did not care if the US President had misunderstandings with regard to the former. 

Riyadh moving closer to Beijing?

Earlier this year, in January 2022, during a meeting between Chinese Defense Minister Wei Fenghe and Saudi Deputy Defense Minister Khalid Bin Salman, there was a focus on strengthening defense ties. Saudi Aramco and China’s North Industries Group (Norinco) have recently decided to take forward an agreement for the development of a crude oil refinery and petrochemical complex in Panjin, China. What is significant is that Norinco is also a defense contractor, and was amongst the eight Chinese companies that joined the recently held World Defense Show exhibition in Riyadh. Significantly, Saudi Advanced Communications and Electronics Systems Company (ACES) signed a strategic agreement with China Electronics Technology Group Corporation (CETC), one of the world’s largest defence companies, to manufacture drone payload systems in Saudi Arabia. 

Abu Dhabi-Washington relations 

The UAE’s ties with the US have also witnessed a downturn. One reason is the UAE’s blossoming relationship with China. US has been uncomfortable with Huawei being part of UAE’s 5G program and had suspected that China was developing a military facility inside the Khalifa Port close to Abu Dhabi. The UAE subsequently cancelled a $23 billion deal to buy F35 jets from the US. 

The UAE has also been unhappy with the US decision not to designate Yemen’s Houthis as terrorists. A missile and drone attack by the rebel group, in January 2022, resulted in the death of 3 people and injured 6. While commenting on the current state of the UAE-US relationship, UAE’s envoy to the US, Yousef al-Otaiba, said:

Today, we’re going through a stress test, but I’m confident that we will get out of it and we will get to a better place.

In conclusion, while the US is looking for ways of minimising the problems caused by the ban on Russian oil and gas, it is absolutely imperative for the US to convince the Saudis and the UAE to start pumping more oil, and for the revival of the Iran nuclear deal at the earliest.

On the Canadian economy: the “real” problem

In Canada, the state of the economy has everyone worried. The fall in oil prices is causing the oil sector in the western provinces and in some of the Atlantic provinces to contract. As a result, everyone has the impression that Canada is sliding towards a recession and governments should act.

I disagree. My disagreement is fueled by two factors. The first is that we should never reason from a price change. The fall in the price of oil is mostly the result of increasing supply of oil. Such a price change is actually a good thing for the Canadian economy. The slowdown in economic activity is merely the result of frictions in the reallocation of resources. The second reason is that the slowdown is caused by “real factors” – policy decision affecting key regions of the Canadian economy. Any government action would worsen a situation caused by too much interference in the first place.

A fall in oil prices can indeed affect the Canadian economy. The oil produced in Canada is generally profitable when prices are relatively high (they require very capital-intensive methods of extraction and refining). An increase in the world oil supply (which is the case right now) would indeed affect the Canadian oil industry. However, Canadians win through lower oil prices – one important input has gotten cheaper. The problem is that once such a slowdown happens, resources are not reallocated without frictions. Business plans are positively affected by the lower oil prices and numerous firms are laying out new plans to expand production. Employment and output will fall in the oil industry before they will pick up in other industries. Eventually, there might even be greater output and employment because of the greater worldwide supply of oil. Right now, Canada is in-between those two situations.

My second reason for dissenting from the majority opinion is that certain regions of the Canadian economy are plagued by poor policy. To make my argument, consider a two-region (West and East) and two-industry economy (oil and manufacturing/services). In the West, the dominant industry is oil. In the East, the dominant industry is manufacturing/services.  The West economy has a more flexible market for inputs (limited regulation, freer labor market and low taxes on capital). The East economy suffers from greater rigidity in its market for inputs – high taxes, burdensome regulation and stringent labor laws.

In a way, this describes the Canadian economy. The provinces of Alberta, Saskatchewan, Manitoba and British-Columbia have been pulling the rest of the Canadian economy for the last twenty years. That’s the West. In the East, the historically poorer province of Quebec has been constantly pulling everyone behind, but less so in recent years as the province of Ontario (the most populous of Canadian provinces) began to slow down. Ontario dramatically expanded the size of its public sector, implemented important regulations and raised taxes – straight in the middle of the recession. In fact, if you exclude Ontario from the rest of Canada, you find (as Philip Cross did) that Canada’s performance is actually quite decent. So in the East, you have Quebec whose policies have not changed and you have Ontario who has adopted increasingly anti-growth policies. The East also has consistently higher taxes. The West has lower taxes. Etc.

Given the accuracy of this stylized description, imagine the effect of a shock on the western economy through a shock on its oil industry. Normally, firms in the East could adapt to lower oil prices by expanding their output in the manufacturing/services sector (thanks to cheaper inputs) while firms in the West contract their output and liberate inputs. However, in the presence of government-imposed frictions, this reallocation of resources is much harder and output has a harder time expanding in the East.

No demand-side policy can solve this problem! You could have easy money and a massive stimulus program, but if firms are discouraged from increasing output, little will happen. In Canada, the current slowdown is explained by “real factors”. Improving provincial policies would be the best channel for improving the state of the Canadian economy.