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Sunday, August 23, 2015

Low oil prices: not a Saudi conspiracy

Mike Smitka

Saudi Arabia is not what it used to be. Their petroleum and other liquids production in 2014, at 11.6 million barrels per day [mbd], is only about 1 mbd above what it was in 1981 (and is just shy of the peak over the period 1980-2013). But their market share is distinctly lower, falling from 17% (of global output of 60.6 mbd) to under 13% (of 93.0 mbd). That limits their pricing power.


Elasticities tell the story. The short-term price elasticity of demand is about -0.2, the medium-term one of course is more elastic at -0.5 or greater. [In most energy markets the income elasticity of demand is roughly 1, though recent work finds it is less in the OECD.] So if the Saudis cut output by 10%, global output falls about 1%. That means prices rise 5%. But with the quantity they sell down 10% and prices up only 5%, that means their income falls by 5%. With a population burgeoning in numbers and expectations, and as the ideological seat of the Wahhabi sect that fuels radical Islam – but so far has not seen cause to bite the Saudi hand that feeds them – well, the kingdom can't afford a large income hit. Oh, and they're consuming what to me is a surprising amount of oil.

One other bit of economic logic reinforces this argument: when interest rates are low and prices are low, it makes sense to leave oil in the ground rather than to pump and sell it. Selling turns oil into bank deposits, and those earn nothing. Leaving oil in the ground also provides the option to benefit from future price rises [though the option loses its value if prices fall further]. So do you want to store your oil in the ground, or store your oil in the bank? (Those with finance acumen can do the corresponding net present value calculation, and maybe even put a valuation on the option.) For the Saudis, pumping oil makes sense only if their focus is cash flow rather than maximizing national income.

Now if OPEC (or at least the Middle East subset) was a true cartel, the Saudis could count on others cutting back as well. That changes the arithmetic in favor of cutting output. But Iraq needs to pump every barrel they can, and Libya and Iran as well. Such lack of discipline is reflected in the history of OPEC: in the past, whenever prices were low, attempts by the Saudis to drive up prices were offset by rampant cheating by other OPEC members. There's no reason to think today would be different. But in the past the Saudis were big enough to go it alone; today they're not.

Now the other part of the accusation is that the Saudis are after market share, not revenue, and that by keeping prices low they'll drive new entrants out of the market (which means production in the US! - they're our friends?). Of course [to an economist!] in general the predation story does not make sense, because would-be predators incur up front costs that typically far offset any putative longer-term gains. But in this case the story is worse.

Yes, many firms in the oil patches of North Dakota, Oklahoma, Texas and Ohio/Pennsylvania are bleeding badly or in bankruptcy; rig counts this year are down by 50%. But Chapter 11 bankruptcy is a wonderful thing, however horrible the overhead can be in delay and legal fees. Debt disappears, businesses do not. For those businesses that are not viable there's Chapter 7 bankruptcy. The businesses vanish, but the assets get sold – they don't disappear. Yes, skilled workers will scatter, but theirs is a geographically mobile existence and they can be enticed to show up again. (The on-again off-again nature of such work is one reason wages are so high.) Oh, and 50% remain, and those 50% are drilling in the best spots and/or have the lowest costs. So the moment the Saudis think they've won and ease up on the pump, well, the US industry will be back in business. What then would the Saudis gain? – a period in which they get less money for what they pump, but no ability to enjoy years of high prices! The Saudis understand this very well.

In sum, the claim that the Saudis are pumping a lot of oil to try to drive new producers (particularly US frackers) out of business is ludicrous. To reiterate, low prices may curtail additional drilling today, but that's scant help to Saudis in keeping prices high tomorrow and the day after.

Data: Energy Information Agency, Monthly Energy Review. Using "Total Petroleum and Other Liquids instead of "Crude Oil Production" does not change the percentages more than a tad but production volumes are higher. The historic series for the latter longer, so I created a second chart. For rig counts and other current data, see WTRG Economics.

Further reading:

Butler, Nick. "Oil Prices – The Saudi Dilemma." FT Blogs | Nick Butler, August 16, 2015.
This is a puzzling presentation of the predation line by an experienced and generally thoughtful energy analyst. What Butler is saying is that the new King Salman bin Abdulaziz al-Saud and his young (age 30) economics deputy Crown Prince Muhammad bin Salman don't understand what they're doing. (On re-reading he doesn't mince words, stating the King, age 79, and oil minister, age 80, are "out of touch.") I'm a sceptic, and believe it really is in the leadership's interest to pump a lot of oil – but history is full of potentates in their dotage who aren't well advised, or (in this case, with the King a newcomer) who in the interest of cementing their hold on power ignore experienced advisors whose tenure goes back to their predecessors.
Gately, Dermot, Nourah Al-Yousef, and Hamad M. H. Al-Sheikh. 2013. “The Rapid Growth of OPEC’s Domestic Oil Consumption.” Energy Policy 62 (November): 844–59.
It's not just China that's increased petroleum consumption. I was surprised by the magnitude of OPEC's thirst, I obviously need to work against my presumption that populations in the Gulf region are too small for their consumption to matter.
Hamilton, James D. 2008. “Understanding Crude Oil Prices.” Working Paper 14492. National Bureau of Economic Research. http://www.nber.org/papers/w14492.
This is a good overview of issues. Warning: Hamilton is among other things a very good econometrician, and the overview assumes a familiarity with the technical jargon of economics, e.g. "random walk without drift". He blogs (with Menzie Chinn) at Econbrowser.
Hochman, Gal, and David Zilberman. 2015. “The Political Economy of OPEC.” Energy Economics 48 (C): 203–16.
They provide more (and more current) detail than Hamilton on the behavior of OPEC. It is as the name plainly says an "organization." It is (empirically) not a cartel, whatever pronouncements individual oil ministers may make from time to time. Remember, to an economist deeds speak louder than words.