Reading the signs behind plummeting oil prices: Saudi-led price war or simple supply and demand?

Published October 19th, 2014 - 11:31 GMT
Saudi Arabia will make sure it will sell its oil first, regardless of the state of the oil markets.
Saudi Arabia will make sure it will sell its oil first, regardless of the state of the oil markets.

The price of the West Texas Intermediate fell on Thursday to below $80 per barrel for the first time in years. What seemed like a sustained collapse in international oil prices led to a flurry of analyses, some of which attributed the trend to a political decision – taken by Washington and executed by Saudi Arabia – to sabotage the economies of Russia and Iran by shrinking their oil revenues. But is there any substance to these allegations?

The “political” explanation of the oil price crisis has been advanced in a number of Russian and Western reports, which recalled the oil market collapse of 1986 and the role of Saudi Arabia in sabotaging the prices of crude oil by increasing production abruptly. Today, many historians consider that move to have been a US-designed strategy that ultimately succeeded in strangling the Soviet Union into collapse, since oil revenues were the USSR’s primary source of hard currency.

In March, Ronald Reagan’s son Michael wrote an editorial addressing President Barack Obama, reminding him of what his father had done, when he went to the Saudis in the 1980s and got them to flood the market with cheap oil. Reagan recommended a similar strategy against Putin, and wrote, “But if our president is really serious about getting Putin to lay off Ukraine and think twice about rebuilding the Soviet Empire, he should follow the Reagan rule. He should put the economic screws to Mother Russia and bankrupt her until she starts clamoring for pantyhose.”

In effect, Saudi Arabia surprised the markets when, as prices slumped below the $100 per barrel mark that has been the average price for the last few years, it announced discounts in oil sales contracts, meaning that its oil would be offered $1 lower than international prices in the Asian markets, and 45 cents lower in America. This drove prices into a rapid downward spiral last week to their lowest levels in years, with reports predicting the slide would continue for a sustained period, suggesting it would bottom out at below $70 per barrel.

Why we’re not in 1985

It is possible to make historical comparisons between the current situation and previous scenarios, but these do not include the Saudi intervention in the oil markets in late 1985, which led to the dramatic collapse in prices. In 1985, OPEC output rose by more than 4 million barrels in the space of a month, with the increase coming mostly from Saudi Arabia, Kuwait, and the UAE.

The debate has not yet been settled over the motives of America’s allies for increasing output and ignoring agreed upon OPEC quotas, and whether the decision was purely economic or a political strategy in the framework of the Cold War, imposed by Washington on its allies. Regardless, what allowed Saudi Arabia to play that role had to do with the specific structure of the oil market imposed by events in the 1970s, conditions that no longer apply today.

Since oil prices rose in 1973, OPEC played the role of market regulator, meaning effectively that OPEC had a spare productive capacity to the tune of millions of barrels, which allowed it to balance supply and demand whenever the need arises. By the early 1980s, global spare productive capacity was more or less OPEC’s spare capacity, while producers outside the organization such as the US, Canada, and Russia pumped as much oil as their reserves allowed, regardless of the state of prices.

Most of the spare productive capacity was in the hands of Saudi Arabia, which had reduced its oil exports to a large extent since the late 1970s with a view to preserve prices. There was a dispute between Saudi Arabia and OPEC regarding the best way to control the market: OPEC preferred controlling production and increasing or decreasing it through agreed upon quotas, while Saudi Arabia was opposed to this approach, and preferred defending a certain price instead of controlling the level of supply. In other words, Saudi Arabia would offer oil in international markets at the price it deemed suitable, and adjusted its output in accordance with the demand it had on the basis of its price. This led Saudi output to decrease its output from 10 million barrels in the late 1970s to less than 3 million barrels in 1985.

This difference between production capacity and actual production (more than 8 million barrels per day in Saudi’s case in the mid 1980s) represents the spare productive capacity. This capacity put Saudi Arabia in a position that allowed it to manipulate the oil markets at the push of a button, as happened in late 1985, and also allowed it to offset lost Iraqi and Kuwaiti output combined in 1990, when it raised its production to approximately 9 million barrels per day, a level it has maintained to this day. This made it easier for the United States to fight the Gulf War in 1991 without pressure from the energy markets, isolate Saddam Hussein and dispense with his oil output, and prepare for a war on Iraq for a period of nearly one year without affecting the market.

Today, the situation is completely different. Saudi Arabia does not have a spare productive capacity, and will not be able to flood the market with additional exports. In fact, many experts believe Saudi production in recent years is equivalent or close to its maximum productive capacity, and perhaps the most important development in the oil markets since the 1990s revolves around this point in particular: the fact that OPEC has lost its productive maneuverability margin it once had, after years of disputes among member states over quotas. This means OPEC’s ability to intervene on the supply side is minimal, as OPEC knows well that securing the approval of its member states over serious cuts and their adherence is impossible.

Production fundamentals today

If Saudi Arabia no longer has the same influence on the markets it once had, what can explain the slumping prices observed today, at a rate that exceeds the relative downturn in the oil markets felt usually in autumn? If there is a historical precedent that resembles the situation today, it would be the period between the late 1970s and early 1980s, when the surge in prices in the previous decade led to a boom in Western oil production, and the development of resources and fields that were technologically challenging or commercially unviable in light of the low prices. Since the late 1970s, oil from Alaska and the North Sea entered the oil markets forcefully, fulfilling the growth in global demand and causing a boom in supplies that gradually reversed the continuous rise in international prices, with stagnation ensuing in the markets that lasted until the end of the millennium.

Price rises since 2003, in turn, led to a similar boom in Western production, mostly from non-conventional sources this time, specifically shale oil and gas, tar sands, and other types of heavy oil, which until recently, was seen as impossible to extract or as uneconomical. With the exploitation of these new resources, made possible by – in addition to high prices – new technologies that made it possible to extract heavy oil trapped in underground rocks, the trend in US oil production was reversed. US oil output had been declining steadily since the 1970s, reaching 5 million barrels per day in 2008, compared to over 8.5 million barrels per day today. Forecasts indicate the US output may exceed 9.5 million barrels per day in 2016, and most of the extra production has come from non-conventional oil.

This increase in US output, in addition to the return of Iraqi production to the market, and the emergence of new major producers in Africa like Angola, not to mention Russian output increasing to levels that approach those achieved by the Soviet Union in its latter years, is behind the saturation in the market today.

These factors have been coupled with a global economic recession that has prevented the Asian market, the only market that continued to expand at great pace these days, from growing at the same stellar rate as in the previous years and absorb the surplus production.

The price game

What many analysts focusing on political motivations do not pay attention to is that the pricing of oil involves complex equations and thresholds, exceeding which is likely to backfire. There is always a price threshold that could lead to structural shifts in the market if the price of oil fluctuates dramatically, up or down.

The most important of these factors has to do with the extraction of heavy oil. While the cost of extracting one barrel of oil in Saudi Arabia does not exceed $3, stimulating oil stuck in underground rocks or heating tar sands to liquefy them are extremely costly processes that consume a lot of resources and energy. For this reason, a sharp and sustained decline in oil prices could drive these oil types out of the market and lead to the collapse of a large number of energy companies, which usually fund their operations through loans on the basis of a price of over a $100 per barrel.

According to McKinsey and Company, an energy consulting firm, the majority of shale oil producers in America require a price of over $75 per barrel to maintain their profitability. Sources in the energy industry say that investments would be scaled back, in addition to shutting down wells with low production, as soon as prices drop below the $85 mark. The first to feel the effects of the crisis would be Canadian heavy oil, before the United States. The problem of non-conventional Canadian oil does not just lie in its high production costs, but also the cost of its production: while the cost of transporting oil from the Arabian Gulf does not exceed $3 per barrel, moving oil from western Canada costs between $12 and $15.

The reason is that production takes place in inland areas far from the coast and export terminals, and also to the fact that Canadian oil extracted from tars and asphalt is heavy and dense, requiring large pumping power to move it through thousands of miles of pipelines to the Gulf of Mexico or the US east coast. Finally, this oil is already sold at a discount – because of its poor quality – which increases greatly whenever the market weakens and supplies increase (the discount reached nearly $20 per barrel last year).

In this sense, there are certain limits for the decline in prices after which production starts to decrease, starting with the costlier fields and those that are farthest from consumption zones. When this happens, the price dynamics are reversed and pressures on the market are relieved. For this reason, some experts believe Saudi Arabia’s goal is to keep oil prices within suitable levels, which would limit supplies without shaking the markets and threatening energy companies in the West.

In the 1980s, the Saudi strategy was to defend prices, a strategy that was abandoned when Saudi increased its exports dramatically in late 1985. Today, Saudi is defending its market share. By offering discounts on export contracts, it is guaranteeing buyers for its massive production.

In the 1980s, Saudi Arabia was telling rivals it was able to crush them through its productive capacity, as the collapse in prices did not affect its overall revenues (price declined to a half almost, but Saudi production had doubled). Saudi’s message to the markets and producers today is that its oil is the most competitive in the world, and that the kingdom would be the last to be affected by slumping prices. Therefore, Saudi Arabia will make sure it will sell its oil first, regardless of the state of the oil markets.


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