Betting on the counterintuitive? Understanding Saudi Arabia's logic, or lack thereof, behind not cutting oil output

Published December 16th, 2014 - 03:45 GMT
However, the Syrian civil war exposed deep splits within the Opec, notably between Saudi Arabia and Iran.
However, the Syrian civil war exposed deep splits within the Opec, notably between Saudi Arabia and Iran.

The world oil market was remarkably stable between 2011 and 2014, with Brent crude trading in the $100-$128 range, despite spikes after the fall of former president Mubarak, the Benghazi revolt against Colonel Gaddafi and the ISIS seizure of Mosul and Anbar Province. The world assumed that, despite a surge in US shale oil, Saudi Arabia world cut output to keep prices above $100 Brent.

However, the Syrian civil war exposed deep splits within the Opec, notably between Saudi Arabia and Iran. Moreover, Iraq increased its production above 3.4 million barrels a day and completes fiercely with Saudi Arabia for the vast Chinese downstream market. The Opec had an economic but no political rationale for an output cut. Saudi Arabia made it clear that it was not willing to play the role of swing producer when Brent fell below $90 and Saudi Aramco actually cut posted prices to Asian refineries when prices were near $80.

Even then, oil analysts and “kingdom watchers” (a specie similar to Kremlinologists during the Cold War) in the Middle East assumed that Riyadh would at least signal a token output cut. After all, in 2009, Saudi Arabia had played its role of swing producer when Oil Minister Ali Naimi and his deputy Prince Abdel Aziz bin Salman engineered the biggest, most successful output cut in the history of the Opec. Oil prices had risen from $38 a barrel in December 2008, in the depths of the global financial crisis, to $100 by 2010. In early 2011, the Arab spring began and the oil market began to price in a geopolitical risk/supply shock premium as Libya, Yemen, Syria, Sudan, Iraq, Iran and Nigeria experienced periodic outages.

Saudi Arabia produces 9.6 million barrels a day, roughly one-third of Opec production. Saudi Arabia is also the lowest cost producer in the Opec, with at least two million barrels of spare capacity and has now amassed $780 billion sovereign wealth assets with government debt a minimal three per cent of GDP. Saudi Arabia long used its production and pricing decision in the oil market for achieve its national security and foreign policy objectives. It will no longer defend $100, $90 or even $80 Brent, as was the case in 2009-14. This is despite the massive rise in post-Arab Spring welfare spending, which has raised the Saudi budget break-even price of oil from $65 to $90 a barrel.  Oil prices rose from $10 in 1998 to $148 in July 2008. However, this 14-fold increase in oil prices met with minimal Saudi response, even though $120 plus oil prices caused demand destruction in the kingdom’s sole strategic export commodity. The 2008-09 Saudi output cut was the exception, not the rule, in the history of the Opec. Saudi Arabia knew an output cut would be pointless at a time when US output had risen three million barrels a day since 2011 (the equivalent of adding another UAE or Kuwait to global oil supply) and oil demand growth in 2014 was not even half the IEA’s projected 1.3 million barrels. Even the oil market assumption that Saudi Arabia would never allow prices to fall below its budget break-even price of $90 was wrong. The kingdom’s foreign assets and minimal public debt means that it can run a budget deficit as it has in the past. 

The November Opec meeting in Vienna was a predictable shock Saudi Arabia, Kuwait and the UAE all failed to assume the swing producer role in the Opec, Saudi Aramco, Kuwait Petroleum and Adnoc actually cut posted prices to their Asian clients after Vienna. This led to panic selling in the oil market, the “Thanksgiving Day massacre” when Brent crude fell from $80 to $67 a barrel.

Oil prices are hugely important for global economic growth and the political stability of the Arab world, Iran, Russia, Nigeria, Angola, Venezuela, etc. There is now a new paradigm in the world oil market. The US is a far more important energy superpower than either Russia or Saudi Arabia because its shale oil producers are continually using technology to drive down their “lifting cost”. US producers could well respond to lower prices by becoming more efficient in the Bakken (North Dakota), Marcellus and Eagle Ford (Texas). The recession in Japan, Europe, Brazil, Russia and a major slowdown in China means world oil demand growth could continue to fall in 2015. If Brent falls below $50 a barrel, a Saudi Arabia could finally decide to coordinate an output cut with the Opec, though Riyadh’s relations with Tehran, Baghdad and Moscow are tense. Monetary conditions also argue for lower prices. The dollar is strong against the yen, euro, rouble and most commodity currencies. The Yellen Fed will be forced to raise short term US dollar interest rates. The Pentagon, the world’s largest user of energy, is downsizing. Unless Saudi policy shifts again, oil prices cannot rise.

 By: Sarie Khaled

The writer is a Dubai-based research analyst in energy and GCC economics.

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