Remarks to a Panel at the Center for the National Interest
I’ve been asked to speak about the geopolitical aspects of Saudi Arabia’s decision to continue producing petroleum at previous levels despite falling oil prices.
Last June, oil sold at as much as $115 per barrel. Now it’s between $45 and $50. That’s a 60 percent collapse in price. There has been all sorts of speculation about why the Saudis let this happen and don’t seem to want to do anything about it.
Elsewhere, I've expressed doubts about the wisdom of a number of Saudi Arabia’s current foreign policies. But the Kingdom’s approach to the oil market impresses me as intelligently calculated to serve its long-term economic interests, while yielding geopolitical benefits at no real political cost. Before I explain why I think this is so, bear with me as I briefly describe the market environment in which Saudi Arabia and other oil producers operate.
World demand for oil is now about 92 million barrels a day. Altogether, including Saudi Arabia, OPEC can supply about 40 percent of this demand. By itself, the Kingdom can meet about 13-14 percent of it. Saudi Arabia is the only oil producer that can ramp up output to fill an immediate supply shortfall. On pretty short notice, it can add a couple of million barrels a day — about 2 percent — to global oil supplies.
The Kingdom is also a very low-cost producer with reserves that will last for many decades. Many other OPEC members — like most non-OPEC countries — are high-cost producers whose costs per barrel are many times those in Saudi Arabia. Others are running out of oil.
Oil is a globally traded commodity. Its prices are determined partly by the current balance between supply and demand and partly by hopes and fears about future shifts in that balance. Estimates of trends in the balance between supply and demand by traders and guesses by speculators about future prices determine current prices of oil and other commodities. Speculators' expectations are often exaggerated and invite sharp corrections that create market volatility. 2008 alone saw oil prices as high as $147 and as low $47 per barrel.
In the relatively short term, supply can be affected by geopolitical events, like war and civil strife. Recent examples are what happened in Iraq and Libya as well as several times in Nigeria. Rough weather and labor unrest can prevent tankers from loading, leading to supply pinches. But the major factors determining whether supply can meet demand over the long term are investment in new exploration and production, new technologies for finding and extracting oil, and new ways of prolonging production in nearly depleted reservoirs.
Demand for energy is closely related to the rate of growth in the world economy amd to seasonal factors. Natural disasters can have an impact on demand as well as supply. (For example, the Japanese tsunami forced a shut down in nuclear power in Japan and Germany and pushed both back into the fossil fuels market). In the long term, demand for oil is greatly affected by changes in technology that alter its costs of production, the efficiency with which it is used, and the availability of competitive alternatives to it.
If the companies that explore for oil and produce it think prices will stay high enough for them to make a significant profit, they will invest in finding and developing new oilfields or in prolonging output from existing fields. Efforts to find and produce oil from "conventional" sources may take nine years or more to begin to bring additional oil to market, if they succeed.. After an initial, often massive amount of investment, investors then begin to get their money back. New infusions of capital are seldom necessary for many years. Once the original investment has been returned, it's all profit from then on in.
Fracking is different. The lag between discovery and production tends to be much shorter, but so is the time it takes to deplete fields — which must then be refracked to release new oil. The need to refrack on a regular basis means that to keep production going frackers, unlike conventional producers, must regularly inject large amounts of new capital into their companies. This makes them prisoners of their banks. They must not only repay current loans but constantly borrow new money.
For the past five years, prices and expectations about future prices have both been high. Interest rates, by contrast, have been very, very low. This situation encouraged a lot of investment projects, especially in unconventional sources of oil, like fracking and oil-sand development, some of which have been almost obscenely profitable at recent prices. In the United States, over the past four years, oil output rose by two-thirds, displacing imports and making an additional 5-6 million barrels per day available to markets abroad. Meanwhile, Iraq and Libya restored production to an aggregate total of about 4 million barrels a day.
Much of the world has been in recession since 2008. Demand for oil has continued to grow but more slowly than supply and well below investor expectations. By late 2014, global oil supplies of about 93 million barrels a day exceeded demand by about one million barrels, or a bit more than one percent. Inventories of unsold oil were meanwhile growing rapidly.
To traders the oversupply and growth in inventories signaled a clear trend toward lower future prices. Their apprehensions about an expanding oversupply of oil conspired to bring about a price collapse comparable to that in earlier speculative cycles.
Saudi Arabia is used to being blamed when prices seem too high. Now it's being blamed for prices being too low. But the Kingdom had nothing to do with either the increase in supply or the recession-induced decrease in demand for oil. Nor did it bring about the collapse in prices. But its position as the world's swing supplier gives it uncommon influence on expectations. And, as Riyadh saw it, the rapidly falling prices for oil confronted it with some stark choices.
The Kingdom could lead OPEC in trying to reverse some or all of the drop in prices by curbing production to reduce supply. But shoring up prices would enable other producers to continue investing profitably in expanded production from shale and oil sands, as well as deep-sea drilling. It would therefore allow higher-cost producers to continue to gain long-term market share at Saudi Arabia and other OPEC members’ expense. If OPEC members cut production, prices might rise somewhat but they would likely stabilize at levels that would still result in less revenue for the Kingdom and also slow, if not end, savings needed to fund the transition to an eventual post-petroleum Saudi economy. More damaging still, loss of future market share would cut the Kingdom’s future revenue from oil as well as its global clout. Adding insult to injury, the main beneficiaries of an OPEC production cut and consequent stabilization of oil prices would be the Iranian and Russian governments and American and Chinese consumers, not Saudi Arabia or other Arab oil producers.
Alternatively, Saudi Arabia could do nothing, accepting the loss of significant current revenue but allowing prices to fall to levels at which its competitors could no longer produce profitably or invest with confidence in new capacity to meet future oil demand.
For Riyadh, this is a “no brainer.” It is clearly smarter to eliminate current and future competition and assure future market share than to help competitors remain profitable at the expense of Saudi and other Arab oil producers’ patrimony and well-being in the decades to come. There are many reasons for this. I'll give you seven.
First. Low prices don’t hurt the Saudi national oil company, Saudi Aramco, much. The world’s biggest oil company does not disclose its production costs, but estimates center around an average of $5-6 per barrel. In general, it appears to cost about $70 to produce a barrel of shale oil in the U..S. (Some U.S. fracking is profitable at $40 per barrel but some requires a price of $90 or more to break even.) Oil-sand-based production comes in at about $80-$90 a barrel, plus transport, which can be expensive. Saudi Aramco and other Gulf Cooperation Council oil companies make a lot of money with oil at $50 a barrel. Many other producers can’t turn a profit at that price.
Second. Low oil prices both halt investment by high-cost producers and inhibit any switch to energy sources other than oil. They affect not just fracking but deep-water drilling, Arctic exploration, expanded reliance on natural gas, and the development of alternatives to oil, including renewable energy sources (which have just become much less competitive than before). Lower oil prices also help force older, depleted fields out of production earlier, further reducing current and future supply. Major project investment will not go forward. Fracking and refracking will lose the access to bank loans they depend upon. All this sets the stage for a minor price rebound to $65 or so in a year or less and a much bigger price rise a few years later. Better to maximize income over the long run than go for short-term revenue.
Third. The Kingdom’s foreign-exchange reserves of about $900 billion are one-fifth larger than its GDP and almost four times its annual budget. Saudi Arabia can afford to take a revenue hit for a few years — long enough for others to be wrung out of the market.
Fourth. The countries most negatively affected by low prices are Saudi Arabia’s enemies and competitors. The Kingdom cannot help but be pleased that low prices hurt the Assad regime’s main backers — Russia and Iran, which depend heavily on revenue from oil exports. . Saudi Arabia is not close to Venezuela. Nigeria has emerged as a competitor for the China market. So what if these governments suffer? Meanwhile, low prices benefit American, Chinese, and Indian consumers and deepen their addiction to oil, ensuring a market for Saudi exports once prices return to high levels, as they will once demand again outstrips supply.
Fifth. Cheap oil helps build markets in rising powers like China and India, where future energy demand is concentrated. (Asia already buys over two-thirds of Saudi oil exports, while the Americas now take less than one-fifth.) The Kingdom is cultivating relations with Asian nations to dilute its dependence on the United States. Current prices help in this regard.
Sixth. Both the prospect of several years of low prices and the timely reminder of market volatility that the price collapse has provided help discourage Chinese and Indian plans to develop domestic fracking and impede progress toward self-sufficiency of oil supply in the Kingdom’s most promising markets.
Seventh. The effect of the price collapse has been to demonstrate that rumors of Saudi and OPEC irrelevance have been greatly exaggerated. The Kingdom's prestige has been enhanced.
In sum, the Kingdom’s stance in OPEC and policies on oil pricing constrain future supply growth, inhibit the development of alternatives to oil, and preserve market share for it and other low-cost oil producers. Riyadh has reminded the world and the region of its power, demonstrated its independence, and served its geopolitical interests. It can afford to stick with its strategy and policies until investors in countries producing more expensive oil have been forced out of the market. In time, oil prices will rise, plussing up the Kingdom’s revenue stream. From the Saudi point of view, all this makes sense even without the geopolitical bonuses it brings. The new king, his crown prince, and the crown prince's heir apparent all participated in formulating current policies. There is no reason to expect them to alter their calculus about what's in the Kingdom's interest anytime soon.