What determines Saudi oil strategy?

 In comments, FS asks: “I’m all on board with the thesis that U.S shale will keep producing but from that thesis it doesn’t follow that oil prices will stay very low for the next year. Put differently, what do you think about the determinants of Saudi Arabia’s production decisions?”

I briefly alluded to Saudi Arabia in the last paragraph of this post, but allow me to expand as I puff on my cigar in a tent in the Arabian desert.

(Actually, that photo is from 2007. It was, however, taken in a tent in the Arabian desert with members of the Saudi royal family, whom you need to remember number in the tens of thousands. I had just gotten back from Afghanistan, at least one of this blog’s regular readers was in Iraq, and the whole thing felt even weirder than it would have normally. But I digress.)

I take the Saudis at their word when they say that they will keep pumping, come hell or high water. The Saudis clearly didn’t engineer the price crash, but they’ve decided to take advantage of it. The public evidence we have is that the reason they will not cut production is that they’ve decided to take on U.S. tight oil.

I doubt that tight oil is the full reason. American production isn’t that low cost. In the long run there is a relatively high price floor as long as the United States is the marginal producer. Moreover, the Saudis can’t kill the American industry dead just by keeping prices low for a year or two; once prices rise, the Americans will come roaring back. 

Rather, I think they’re deathly afraid of demand destruction. Their strategists are very knowledgeable. They’ve seen the figures on peak driving. They know about the new CAFE standards. They watch Elon Musk’s every move. They are seeing businesses and governments go after the use of petroleum products in trucking. They are more knowledgeable about biofuels than some of the industry’s biggest proponents. Heck, they are seeing New Englanders switch from oil to wood for heat! And those trends weren’t just in America. They were everywhere.

In the words of the great Saudi oil minister, Sheikh Zaki Yamani: “The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil.” By the middle of 2014, that prediction looked to be coming true. The Saudis could imagine a future where oil prices stayed high until sometime in the middle of the next decade and then began an inexorable plunge down towards zero.

Tight oil might be hard to cripple with a temporary period of low prices, but such a period really can do serious long-term damage to the creation of substitutes. Human capital will dry up, investors will run away, organizations will be liquidated, policies will be reversed (or not implemented) ... and millions of consumers will not change their consumption habits. When prices go back up, all of those changes will take years (or decades) to reverse.

Low prices do all that while striking a minor blow against American tight oil, a major blow against the Islamic Republic of Iran, and making the Americans happy! 

There is also some element of a replay of 1986 in the decision to let prices stay low: in November the Saudis tried to get the Russians to agree to cuts and were miffed when a hard-pressed Vladimir Putin said no. Punishing Russia serves a double purpose, then: your American protectors like it and it makes your threats more credible the next time you try to organize a production cutback. 

Sure, the Saudi budget goes into deficit when oil is less than $100. But with their foreign exchange reserves, that is less than a problem. $38.6 billion deficit? Nada. Saudi Arabia has foreign exchange reserves around $740 billion. Judging from the Saudi balance of payments (page 34), they earn a pathetic return on that $740 billion; maybe 1.5%. (No r>g here!) They could avoid dipping into their insanely high reserves just by a little more aggressive investing and some asset privatization. (Norway gets 6.7% on its money; r>g over there, and the Norwegians will own us all.) Hell, the Saudis could earn an additional $30 billion next year (at $40) just from letting their production rip: last year they kept a whopping 2.4 million bpd of capacity in reserve. 

In other words, I do not think that Riyadh is going to try to drive oil prices back up for some time. 

Comments

[shah8]

Do you think they intend to let the global economy buoy oil prices when it's ready to go up? Or decide to pull oil off the shelf in some secret or public agreement with other producers/consumers after a while?

[Noel Maurer]

Could you rephrase? I'm not sure I understand the question.

[shah8]

Yeah, I kind of thought that wasn't clear.

I think perhaps a better question, for pretty much what I was getting at...

Is there a reasonably possible scenario where Saudi Arabia unilaterally takes oil production offline?

[Noel Maurer]

Gotcha! That's clear.

If prices stay low even after U.S. production starts to decline, then the Saudis will cut. Similarly, if demand shows signs that the secular decline in consumption has reversed itself then Saudi will cut. Third, if non-OPEC producers agree to go along, then Saudi will cut.

More long-term, if in the future oil prices decline sharply (but without the worrying long-term trends of U.S. tight oil and potential substitutes) then Saudi will cut. If the current slump goes on for two years and then newly-inaugurated President Bush signs a reformed Clean Air Act, then watch for Saudi Arabia to revert to form.

The Saudis have stated that $75 per barrel is their sweet spot. I believe them simply because that is a logical price --- high enough to earn massive rents, low enough to keep out the competition and discourage substitution.

http://www.telegraph.co.uk/finance/newsbysector/energy/5387261/Fair-price-for-oil-is-75-80-a-barrel-says-King-Abdullah-of-Saudi-Arabia.html

[Andrew R.]

So what's your spot judgment on how successful the KSA will be at kneecapping a lot of the development of "green energy" that we've seen over the last decade or so?

[Noel Maurer]

Not very.

Most of the headline stuff is used to generate electricity; the price of oil isn't relevant. And the new CAFE standards will be impossible to change outside an act of Congress, although a Republican president could slow implementation. (See this link for the new rules: http://www.epa.gov/otaq/climate/documents/420f12051.pdf.)

Where it will hit is in the below-the-radar stuff: switching heating systems, mandates for energy efficiency, that sort of thing. For example, now that I'm a homeowner, I really understand just how goddamned hard it is to insulate your home ... even if the investment would be NPV positive. Far better a mandate that sends a government official around to tell me what I need to do and makes me pay for it. We don't use fuel oil in our house (thank the Lord) but the places that do are less likely to switch. And attempts to push standards on freight transport are now dead in the water.

But that's small beans, I think. Green energy has other problems, none of which are caused by low oil prices.

[Jonathan]

Relevant to your last comment, our apartment building just switched the boiler to natural gas from heating oil last year. I bet the management company is kicking themselves now, although I am much happier as the fuel truck is noisy and no longer makes visits to our place.

You have yourself remarked on the effectiveness of the heating system.

[FS]

Fascinating, thank you! I appreciate the comments about it not being about tight oil yet still related to "predatory pricing" in general. I suppose we'll have an interesting test as to whether predatory pricing works at all (though we'll have difficulty picturing the counterfactual).