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Tuesday, April 26, 2016

Another fracking Saudi conspiracy story, or Chapter 11 is a marvelous invention

Mike Smitka

Let me revisit a topic that matters a lot to the auto industry, what's happening in the energy sector. Frank Gaffney, of the Center for Security Policy, is pushing a case against Saudi Arabia. While this may be a good thing for him to do to drum up business in the national security arena, the claim that "Saudis Waging ‘Economic Warfare’ Against U.S." (this is as reported on the web site of something called the Open Fuel Standard). This is laughably wrong, except for it involving a set of serious policy issues.

low prices can’t destroy the fracking industry, they can only change who owns the debt

To quote:

“You know, they said explicitly when they were driving down the price of oil ... that they were doing it to destroy our fracking industry. That is a hostile action. They’re now talking about dumping Treasury bills ... That’s an act of economic warfare as well."

First, the Saudis are desperate for cash flow, but the only thing they can do is to produce more. They’re simply not big enough. If they cut output 10% global output drops by under 2% and prices only go up by less. Let's be wildly optimistic and assume prices rise 2%, more than any demand elasticity estimate I've seen. That means their total revenue drops 8%. [The arithmetic is P(1+2%)Q(1-10%) which is original revenue PQ(1-8%).] So if they cut output they cut their own throats (or more accurately, invite a palace coup or worse that will cut their throats for them). Next, the secondary recovery they’re using also makes cutting output hard, they lose output permanently. [Once they stop forcing high-pressure water around the perimeter of fields and the compensating withdrawal of oil from the center, oil will flow back towards the edges and they'll be unable to get it out.] Third, OPEC is not a functioning cartel where the Saudis can get others to coordinate to cut output. It’s too big a group and there’s no enforcement mechanism, everyone cheats to the point that agreements are meaningless. That's been true in the past – empirical work by both economists and political scientists – and nothing has happened to change the incentives of Saudi Arabia's erstwhile co-conspirators. [The theoretical case requires that members can monitor output, and that they have some option to punish cheaters. For OPEC neither holds.] It’s a convenient boogeyman so the myth doesn’t go away.

The Saudis make a good foil for energy debates; it helps that no one feels much sympathy for them. But oil is a global market, and while it's not perfectly competitive, as economists define the term, changes in supply or demand in one part of the globe (the US and China) affect prices throughout the world. Furthermore, the market for petroleum interacts with developments in supply and demand for other sources of energy. In that context, the Saudis have stood out in periods when short-run increases in demand were large relative to the ability of energy suppliers to respond. But that’s not because they held back output, or otherwise did much beyond pump what they could.

Today they are desperate for revenue. What they do is thus dominated by the short run. They have not always been so thirsty, and so short-term in focus. In the past those in the government and Aramco could think about the long run, whether they should pump less when prices were low to have more oil to sell when prices were high. However, even in the past they reacted to the market, they didn't set the market. Their strategic space has shrunk, and they no longer have the option to hold oil production back. Yes, people watch Saudi Arabia. Perhaps their strategic concerns are sufficiently representative of the Middle East that this disproportionate focus isn't entirely silly. But it doesn't mean that their pronouncements will have more than a fleeting impact.

Finally, there's the US end. How long does it take to restart production? Fracking wells see output decline about 60% in the first year, it’s not like wells in Texas that have been producing for decades. [There's one under the state capital building.] If you have cash, you can kit yourself out for the next bump in oil prices at pennies on the dollar, and there are businesses that are doing exactly that. Plenty of pipes in inventory, too, not just rigs. Chapter 11 is a marvelous thing: low prices can’t destroy the fracking industry, they can only change who owns the companies and their debt.

Oh, and dumping treasuries is an old canard that is constantly touted by fearmongers but never observed in practice. If you have a lot of Treasuries and you try to dump them, prices fall and you lose a lot of money. And if you're Saudi Arabia, what will you buy with your dollars, Euros? Those will become more expensive, a double whammy. Now the reality is that the Saudis are issuing debt, not buying debt. So are they selling some Treasuries? Maybe. Have they stopped buying? Already. Have US interest rates spiked? Not at all. OK, I can't resist: what we have is one short, albeit oft-repeated paragraph, Ney-deep in Gaffs, replete with claims that are not fracked up to what they ought to be.

I've updated the content a couple times based on email interactions with others.