Saudi Brinksmanship: Economics Behind Reluctance to Fiddle with Oil Prices



Saudi Brinksmanship: Economics Behind Reluctance to Fiddle with Oil Prices
Much of the downward spiral in crude oil prices results from the maneuverings of Saudi Arabia, points out analyst Faraz Shams.

This analysis piece presents the opinions of the author.
It does not necessarily reflect the views of DownstreamToday.

The freefall in crude oil prices continues unabated. During the latter half of 2014, crude oil plunged to less than half of its value earlier in the year. The sharp decline has sent the major suppliers into a tizzy, and the development threatens to profoundly alter the dynamics of the global oil and gas trade.

Much of this downward spiral results from the maneuverings of Saudi Arabia, which has been instrumental in Organization of the Petroleum Exporting Countries (OPEC) deciding to stop short of withholding production – despite the seeming reluctance of some other members. The speculation market is awash with talks of Saudi Arabia going all out to hurt Iran and nipping the growing shale oil industry in the bud. Moreover, those espousing this viewpoint suspect the Saudi-driven campaign will punish Russia for supporting the embattled Iran-backed regime of Syrian President Bashar Al-Assad in his country's ongoing civil war.

Achieving geopolitical aims with market forces

Despite the temptation to discuss the geopolitical motives of the Saudi government, it would be worthwhile to explore the economic and business rationale of such a move. From the Saudi government's point of view, letting market forces decide the price of oil would help to achieve its geopolitical aims and to reinforce its credentials as the top player in the global oil and gas trade.

Ali Al-Naimi, the Saudi petroleum minister, is not a man who lets emotions get in the way when making business decisions. A long-time official at Saudi Aramco, where he rose through the ranks to become CEO of the oil giant before taking the reins of the petroleum ministry in 1995, Naimi is a seasoned and hugely experienced veteran. By all accounts, he is a calm and deliberate person who would resist the urge to make a hasty decision that would hurt Iran or any other political rival.

Saudi Arabia's decision to let market forces determine oil prices is a cold and calculated one, meant to reinforce the Kingdom’s position as the dominant supplier of crude for the foreseeable future – much to the consternation of some other OPEC members. With low production costs and burgeoning coffers, Saudi Arabia can withstand virtually any oil price for the short- to medium-term – unlike many other OPEC members.

Saudi Arabia’s decision to not tinker with oil prices would go a long way in restoring confidence in the workings of OPEC, convincing global oil and gas consumers the organization is not a retrogressive cartel bent on maximizing profits. More importantly, the move supports OPEC's goal of further strengthening its dominance in the crude market vis-à-vis other suppliers who would have very little incentive to step up production or even maintain existing levels of output. Because Saudi Arabia controls some of the largest and most prolific oilfields in the world, it could easily step in to fill the gap and capture greater market share. Taking on such a role would also enable the Kingdom to optimize capacity utilization at Saudi Aramco's massive production and processing facilities. Such action would also help the west Asian behemoth to tighten its grip over OPEC and reassert itself as the top dog in the oil trade dynamics, a position threatened by the U.S. shale revolution and the rapid development of new Russian oilfields in the Arctic and elsewhere.

Naimi has clearly outlined his approach, and Saudi Arabia aims to “price out inefficient producers” from the market. It is a tricky time for countries like Venezuela and Russia, which have high exploration and production costs. In contrast, consumer giants like China and India that have been bogged down by providing subsidized fuel to their citizens now get some relief.

“The lower oil prices will help the (Indian Prime Minister Narendra) Modi government in the planned price deregulation of petroleum products such as diesel and petrol and would also reduce the subsidy burden on transportation fuel for the exchequer,” Ramesh Joshi, chief analyst at Indian Petro said. “The government has also increased the excise rate for these products, so there is not much change in the retail prices, though,” Joshi added.  

Possible ramifications for the Americas, Russia

On the flip side continued depression in oil prices could seriously undermine the shale revolution in the United States, where producers cannot compete with cheap oil from the Middle East. Such a trend also jeopardizes the economics of exports from the United States, where one project has already fallen victim to less favorable oil price dynamics. Moreover, it would stifle further exploration -- particularly offshore, where explorers would prefer to wait until they get a positive signal about an upturn in prices.

An ongoing oil price slump also could spark unrest in countries that are highly dependent on crude exports. One potential hot spot that is extremely vulnerable to a dip in prices, Venezuela, has already sought help from China as it endures difficulties stemming from a slump in the value of its most prized resource. A similar financing package has been extended to Ecuador, which has been affected as well. China has been keen to expand its footprint across resource-rich Africa as well and would look to step into more countries in the region seeking assistance.

Russia, whose top exports include oil and gas, has been hit the hardest by the downward spiral in prices. The Ruble has lost nearly half of its value against the U.S. Dollar, and Russia’s investment rating has succumbed to repeated downgrades. Along with the U.S.-European Union sanctions already in place, Russia could be in a tight spot if oil and gas prices fail to rebound in the foreseeable future. Iran is another country at risk of facing a similar predicament. Both Russia and Iran are longstanding rivals of Saudi Arabia, and a tumble by either country in the race to the top of the global oil and gas trade would be no major predicament for the Saudis.

In conclusion, the Saudis' reluctance to lower crude production is based more on sound economic and business sense rather than the ulterior political motives often touted in public discourse. Some producers are bound to get hurt in the process, but market forces are invariably favorable only to the most efficient and the most resourceful.