Saudi Arabia: the great oil game

Saudi Arabia just increased oil production to a record level, never reached in previous history. They are doing that in a moment of record low oil prices. What do they have in mind? (Image from Arthur Berman)

When the collapse of the oil prices started, in the summer of 2014, everyone noticed that Saudi Arabia was not playing their traditional role of "swing producers", that is varying their production in such a way to maintain reasonably constant prices. Facing a slump in demand, they should have reduced production; but they didn't.

Initially, I thought the Saudis were simply taken by surprise and they were slow to react. But now, with the recent increase in Saudi production, it is clear that they have something in mind. Maybe they haven't engineered the market collapse, but in some way they are riding it.

Though this be madness, yet there is method in it. But what method could there be in raising production just when prices are lowest? Every single textbook in economics will tell you that the market should adapt to changes in demand and offer in exactly the opposite way: facing a reduced demand, production should go down, too. 

Of course, as we all know, what you read in textbooks of economics has little to do with the real world. And, in the real world, there is a well known market strategy that consists in bankrupting your competitors by selling below cost. The idea is to create a monopoly and recoup later what the winner of the struggle has lost at the beginning. It is, of course, illegal, but the very fact that there are laws against it, means that it is done.

However, there is a little problem in applying this strategy to the oil market. It has to do with the fact that oil is a finite resource. So, if producers manage to obtain a monopoly, that means they will run out of the resource before the others. Imagine you are an art dealer: would you sell your Picassos at low cost in order to undercut the other art merchants and gain a monopoly? Of course not, what you would obtain is simply to run out fast of your precious Picasso paintings and then leave the market fully open to the others. 

So, what are the Saudis doing, exactly? Art Berman suggests that they are fighting against the banks that created the tight oil bubble possible. After the elimination of the bubble, the market might return to relatively high oil prices and maximize the revenues for Saudi Aramco. 

Berman's interpretation is surely possible, but, as in all these cases, we are looking at governments as if they were "black boxes", trying to understand the inner mechanisms that make them move. This is very risky: just as we see in clouds faces that aren't there, we may see in a government's actions a plan that is not there. Are the Saudis really planning for a long term profit? Or are they simply misjudging the extent of their resources? 

After all, we have several examples of non-renewable resources having been managed as if they were infinite. Just consider how the North Sea oil was extracted at the highest possible rate when the oil market was experiencing historically low prices. That left producers with declining oil fields when market prices started increasing. It was not a very smart strategy, to say the least.

In the case of the North sea, there was no long term planning; it was just that the long term depletion problem was not understood. So, are the Saudis blind to the very concept of "depletion"?(*) That's impossible to say at present. The only certain fact is that age of cheap oil is gone; even though some wild oscillations may make us believe that the good times have returned - but just for a while. 




(*) About being unable to perceive that a mineral resource is running out, an especially tragic case is that of Yemen. For a few years, I have been following the "Yemen Times" and. in all this time, I never could read any statement that indicated that the problem of oil depletion in Yemen was understood. Whenever the decline in production was mentioned, it was attributed to terrorism, civil unrest, and other temporary problems. From what I could read, it seems to me that the Yemen society was (and still is) completely and totally blind to the fact that they have been gradually running out of oil and that oil depletion is the root cause of all the troubles that they have experienced, and that they are experiencing right now. (graph from "our finite world")

The oil price collapse: did the Saudis make a smart move?

Saudi Arabia's data on oil production (all liquids). Data from EIA

Arthur Berman recently wrote this on the oil price collapse:

As far as Saudi Arabia and its motives, that is very simple also. The Saudis are good at money and arithmetic. Faced with the painful choice of losing money maintaining current production at $60/barrel or taking 2 million barrels per day off the market and losing much more money—it’s an easy choice: take the path that is less painful. If there are secondary reasons like hurting U.S. tight oil producers or hurting Iran and Russia, that’s great, but it’s really just about the money.

I think that Berman may very well be right; the Saudi really reasoned in these terms. They wanted to reduce their losses and keep their market share.

But think about that for a moment: was it really a smart move for the Saudis?

Saudi Arabia produces little in addition to oil; its economy is heavily based on oil. And even for food, Saudi Arabia must rely on revenues from oil in order to import food. And even for the mighty Saudi Arabia, oil resources are not infinite.

So, assume you have the power to regulate oil production in Saudi Arabia, what would you do? Logically, you would think that it is silly to keep pumping oil at full speed when it has become so cheap. You would reason that it is a good idea to keep as much as possible of it underground, to use when it will be really rare and expensive. In addition, your competitors will run out of oil when you still have plenty of it; wouldn't that be nice?

Logic? Sure, but only if you think long term. If you think only of the near term profit, then it makes sense to sell all what you have, when you have it. And the future? Well, that will be someone else's problem.

Unfortunately, it is not just in Saudi Arabia that they think in this way.

Unleashing the oil weapon against Russia: how to destroy a great empire

The Pythoness of the Oracle of Delphi told to King Croesus that if he were to attack Persia "a great empire will be destroyed." Croesus did just that, but the great empire which fell was not the Persian one, but his own. 

Do you remember the old Soviet Union? Dubbed as "The Evil Empire" by Ronald Reagan in 1983, it disappeared in a puff of smoke in 1991, crushed under a mountain of debts. The origins of the financial collapse of the Soviet Union are rather well known: it was related to the fall of the oil prices which, in 1985, went down from the equivalent of more than 100 (today's) dollars per barrel in 1980 to about 30 (today's) dollars and stayed low for more than a decade. The Soviet Union was relying on oil exports for its economy and, in addition, it was burdened with huge military expenses. It just couldn't take a drop of more than a factor of three in its oil revenues. 

There exists a persistent legend that says that the downfall of the Soviet Union was engineered by a secret agreement of the Western Powers with the Saudi government who agreed to open the spigots of their oil fields in order to bring down oil prices. This is, indeed, nothing more than a legend. Not only we have no proof that such a secret agreement ever existed, but it is not even true that the Saudis played the role attributed to them. In the 1980s, Saudi Arabia, actually, tried hard to avoid the downfall in oil prices by reducing (rather than increasing) its oil output; without much success. (Image on the right from Wikipedia)

It is true, however, that after the first great oil crisis of the 1970s, the world's oil production restarted its growth around 1985.  The reasons for the recovery can't be attributed to the work of a group of conspirators sitting in a smoke filled room. Rather, it was the result of a number of new oil fields starting their production phase, mainly in Alaska and in the North Sea. This was the origin of the drop in oil prices and, indirectly, of the fall of the Soviet Union. (Image on the left from Wikipedia)

Today, Russia's oil production has recovered from the downfall of Soviet times and the Russian economy is highly dependent on oil exports, much like the old USSR was. So, a drop in oil prices could do a lot of damage to Russia. Given the political situation with the Ukraine crisis, there are speculations that the West is trying to bring down Russia by repeating the same trick that seemed to be so successful in bringing down the old "Evil Empire". Indeed, we are seeing oil prices dropping below $90 per barrel after years of stability around $100. Is it a fluctuation or a trend? Hard to say, but it is being interpreted as the unleashing of the "oil weapon" against Russia on the part of Saudi Arabia. 

However, the world of today is not the world of the 1980s. One problem is that Saudi Arabia has shown several times to be able to throttle production down, but never to raise it significantly higher than the present levels; one could even question whether they will be able to maintain them in the future. Then, there is nothing today which could play the role that Alaska and the North Sea fields played in the 1980s. It had been said many times that we would need a "new Saudi Arabia" (or more than one) to offset the decline of the world's oil fields, but we never found it.

Yet, there are good reasons to think that we could see a drop in oil prices in the near future. One factor is the downturn of several of the world's major economies (e.g. Italy). That could lead to a fall of the demand for oil and, consequently, to lower prices (something similar took place with the financial crisis of 2008). Another factor could be the rapidly growing production unconventional oil (largely in the form of "shale oil") is the U.S. This oil is not being exported in large amounts, but it has reduced the US demand of oil in the world's market. Coupling these two factors, we might well see a considerable drop in oil prices in the near future, although hardly a sustained one. So, would that be the "oil weapon" that will bring Russia to its knees? Maybe, but, as with all weapons, there are side effects to consider.

As we said, unconventional oil is playing a major role in maintaining the world's production. The problem is that unconventional oil is often an expensive resource. Then, in the case of shale oil, the decline rate of wells is very fast: the lifetime of a well is of just a few years. So, the shale oil industry needs a continuous influx of new investments to keep producing and it is very sensitive to oil prices. Its recent rise was the result of high prices; low prices might cause its demise. In contrast, conventional oil fields have a lifetime of decades and are relatively immune to short term variations of oil prices. If we see the situation in these terms, we might legitimately ask against whom the oil weapon is aimed. The US unconventional oil industry might well be its first victim.

History, as we all know, never repeats itself, but it does rhyme. King Croesus, at his times, believed the Delphic Oracle when he was told that he could bring down a great empire if he would attack Persia. He didn't realize that he was going to destroy his own empire. Something similar may be in store for us in the coming years: a drop in oil prices might well bring down a great empire. Which one, however, is all to be seen.