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| Saudi Oil Minister |
Introduction: The Fall in Oil Prices in 2015
Crude oil prices temporarily rose because Saudi Arabia signaled that it
would cooperate with OPEC and non-OPEC producers to “stabilize” oil
prices. Nothing specific was
mentioned. At the current price and for
political reasons, it is unlikely Saudi Arabia and its Persian Gulf allies will
cut production or negotiate joint production cuts with other large
producers. The comments are probably an
indication that Saudi Arabia might be part of a global reduction in crude oil
production if prices go much lower and the political situation in Syria changes.
Until recently, Saudi Arabia was seeing the results it
wanted. Some are economic, having to do
with the current and future price and production of oil. The economic targets were shale production in
the U.S and tar sands production in Canada.
The geopolitical targets were Iran and Russia. But unexpected economic and geopolitical
changes have increased the cost to the Saudis of continuing their
policies. Low prices will continue
longer than the Saudis expected. At the
same time, geopolitical changes have made it more unlikely that Saudi Arabia can
change its strategy or negotiate a favorable change in the global oil industry.
Economic Goals
Until 2014, increased production in the U.S. and Canada was
matched by increased demand by China and other developing countries. Prices remained at record high levels, over $100/barrel. But a continued increase in U.S. shale production combined
with slower growth in Chinese and global demand in 2014 led to surplus
production and rising inventories. Since
both global supply and global demand are inelastic, a small percentage increase
in global supply relative to global demand led to a decrease in exports and a
large decrease in price. Thus far, about
45%.
The fall in the price of oil is part of a bigger picture,
the fall in the price of virtually all globally-traded energy products,
minerals, metals and agricultural products.
Strong growth in global demand before and after the last recession, led
by China, encouraged countries and companies to expand capacity and production
in almost all commodity industries. A
slowing of global growth resulted in excess supply and large decreases in world
prices. This implies that the pricing and supply problems of the global oil industry is not just caused industry variables but is part of a larger global trend of slowing manufacturing and exports.
Oil production in many countries cannot be reduced for
domestic political reasons. In some countries, the state owns or controls oil production and relies on oil export income for government revenue, earning hard currency to service rising foreign debt and maintaining employment and politically-necessary welfare programs and subsidies. In countries like the United States, where oil production is done by private companies, producers try to maintain output as long as price is above marginal production costs, thus contributing to covering ongoing financial costs
(interest and principal payments on increased levels of debt) and avoiding penalties for shutting down output of producing wells.
Saudi Arabia and its allies knew if they cut back production
and the price of oil rose, other countries and companies would expand
production. American shale production
would continue to increase if the domestic price (WTI, a few dollars below
Brent, the world benchmark price) stayed above $60/barrel. At the current price range of $40-$45/barrel,
some American production has been shut down and most drillers are
losing money. But total production has not gone down as far or a fast as the Saudis expected. One reason is that many of the drillers hedged the price of some of the oil they sold when the price began to fall. Another is that production costs are falling, partly due to new drilling technology. Their average selling price is high enough to cover lower marginal drilling and ongoing financial costs. Some are even making a profit.
The only question is how
long will it take for some American shale companies to go bankrupt and the rest
to decrease production further.
Apparently it is taking longer than the Saudis expected. American
shale producers have cut costs of production, squeezed suppliers, and become
much more efficient, reducing their marginal cost break-even price. But a high percent of operating revenue is going to debt repayments. A few highly leveraged producers have gone bankrupt. Production assets are being sold to other companies.
Oil producers are still losing money, their bankers
are getting nervous but total production has only decreased about ½ million
barrels/day. If oil prices don’t rise to around $60/barrel before the middle of next year, the decrease in production will accelerate.
Many of the hedges come off this quarter and the first quarter of 2016. We should see increased financial pressure on drillers in the second quarter of 2016. The Saudis can wait that long to see how quickly the financial position of American producers deteriorate and if declines in production accelerate.
Russia has also reduced its cost/barrel and break-even price by applying new technology, better organization and apparently lower taxes and fees on oil production.
Saudi Arabia has actually increased production after
completing a $100 billion modernization and expansion of their oil
infrastructure. The increased production
and processing was for increased domestic consumption and more refining. Exports have remained
constant. In the future, more of Saudi oil exports will be refined products and petrochemicals rather than crude oil. This put them on a collision course with U.S. refineries, who have dramatically increased exports of refined petroleum products.
Saudi Arabia has been
fighting hard for market share. They
have taken market share away from Russia in China by offering larger discounts
off list prices. They have also increased
sales to Europe by also offering lower prices.
This is one of the benefits of being the world’s lowest cost producer
and having a $700 billion sovereign wealth fund. But the government is running a huge deficit relative to GDP. At some point, the combination of lower oil revenue, large government deficits, the proxy and air war in Yemen, supporting Sunni militias in Syria, and the need for newer military equipment may force the Saudi government to reconsider its geopolitical strategy. And, as discussed below, a change in American policy in the Middle East might be another reason for changing its oil strategy.
A major goal of Saudi Arabia’s low-price strategy was to reduce global investment in oil exploration and production capacity. This seems to be working. A year of low prices has led to the
cancellation of many oil capital projects to maintain production in old fields
and open up new fields in other countries.
So far, industry analysts think about $200 billion of capital projects
have already been cancelled or delayed. Many U.S. shale drilling rigs have been taken out of production. This means
less global oil production in the future, higher prices and a stronger long-term
position for Saudi Arabia. And possibly for the United States. When WTI crude prices go above $60/barrel, or possibly lower with the continuing reduction in production costs, U.S. shale production will start expanding and new drilling will raise production above the recent level of 9.2 million barrels/day.
Geopolitics and Religion:
Saudi Arabia, Iran and Russia
Saudi Arabia and Russia are the world’s two largest
exporters of oil. Between them and with Saudi
Arabia’s allies, they could jointly reduce exports and raise world prices. As long as the world price stayed below $60/barrel, most U.S. shale producers would continue to lose money and probably be
forced to reduce production further.
This would also reduce the economic pressure in Russia, which is in
recession. Russia would probably run a larger trade surplus and earn more hard currency to support domestic debt and reduce the government’s deficit. Russia might also decide to match Saudi discounts. Europe still depends on
Russia for most of its imported oil and natural gas. If Russia can maintain its dominant position in Europe, the end result might be the lifting of European sanctions and more Russian interference in Ukraine.
But geopolitics has intervened. Iran, subject to punishing economic
sanctions, agreed to delay its nuclear weapons program in exchange for the
lifting of the sanctions. This resulted in tens of
billions of dollars becoming unfrozen and Iran could increase oil production and
exports. Iran has said it will use some
of the money to modernize and expand its oil industry, increase exports by ½
million barrels/day almost immediately and continue to increase production and
exports in the future. This negates the
Saudi’s strategy of reducing global production by pressuring American shale
producers.
There is no way that Saudi Arabia will do a deal with Iran. They are bitter enemies. Besides rivals for control of the Persian
Gulf, Iran is the leading Shia country in the Middle East and Saudi Arabia is
the dominant Sunni country. They are
fighting a war by proxy in Yemen.
To make the situation even more bitter, if possible, there
is Syria. The Syrian government is Shia,
supported by Iran, and Iran’s and Syria’s client, Hezbollah. Both Iran and Hezbollah have sent troops and
military aid to the Syrian government, whose main opponents are Sunni, including al-Qaeda
and Islamic State.
The Syrian government has long been a client state of Russia. Vladimir Putin has decided to give military
aid and air power support to Syria. After Turkey shot down a Russian bomber, Russia increased the military technology, and probably the number of Russians, it based in Syria. It
is highly unlikely there will be a political settlement in Syria, where Shias are
in the minority, that would be acceptable to the Syrian president, Russia, Iran, Saudi Arabia and the Sunni opposition groups.
Russia has also signed economic and technical agreements
with Iran. Any chance that Russia and
Saudi Arabia would cooperate to reduce global oil production in the near future has disappeared.
The United States and Saudi Arabia
One reason that Russia has initiated more contacts with
Iran, and supported Iran’s goals in Syria, is that it appears the Obama
administration has been slowly moving away from the alliance with Saudi Arabia
and towards some sort of détente with Iran.
Washington worked hard to come to an agreement with Iran, despite past
animosity. Also, American support of
Saudi Arabia’s bombing campaign of Shias in Yemen has been almost invisible.
The United States (and Russia) have learned some bitter
lessons about the limits of military power in Afghanistan and the Middle
East. Maybe it is time to review
America’s reliance on Saudi Arabia as an ally.
Think of the history:
Going as far back as Franklin Roosevelt, the U.S. and the
House of Saud agreed that Saudi Arabia and American oil companies would supply
America and its allies with oil at low prices in exchange for American
protection of Saudi Arabia and its oil fields. Since then:
Saudi Arabia has nationalized its oil fields and kicked out
American oil companies (and their alien influence).
Saudi Arabia has twice cut off oil exports to the United
States.
OPEC, dominated by Saudi Arabia and its allies, increased
the price of crude oil by a factor of 10 ($3/barrel to over $30/barrel) between
1973 and 1979.
The Saudi government supports a fundamentalist version of
Sunni Islam (Wahhabi) and spends money to spread its version of Islam throughout
the Muslim world.
Wahhabi Islam is the theological justification for al-Qaeda
and its offshoot, Islamic State.
Al-Qaeda was originally begun by Saudi Arabia and America as a weapon to
fight the Russians in Afghanistan. After
the Russians left, did America think that al-Qaeda would disband? Did American leaders think that al-Qaeda
wouldn’t go after secular Muslim states and not remember that Islam has been
fighting against Christian states for over 1,300 years?
15 of the 19 terrorists involved in the 9/11 attacks were
Saudis. None of the subsequent terrorist
plots or bombings in the U.S. or Europe were by Shias.
Saudi Arabia remains one of the most repressive countries in
the world, complete with religious police.
America no longer needs Saudi oil. The U.S. imports only 400,000 barrels per day
of Saudi oil, only because Saudi Arabia sends the oil to American refineries it
partly owns.
America’s protection of Saudi Arabia and its oil fields has come at a high price. The United
States committed most of its front-line military to defeat Iraq when Iraq invaded
Kuwait and threatened nearby Saudi oil fields.
Subsequent military involvement in the Middle East has strained American
military resources and diverted resources from Afghanistan. One result has been
the hollowing out of NATO, which could have serious consequences for America’s
position in Europe. Eastern European
leaders, eager in the past to join NATO for protection from Russia, have
expressed doubts about how much military and political support they could
expect from NATO in light of increased Russian pressure. America’s almost total lack of support for
the pro-West Ukrainian government has made Eastern European governments more
nervous and, in some states, led them to reconsider their relationship with
Russia. A few have called for ending
economic sanctions against Russia.
Conclusion: Implications for U.S. Foreign Policy
The problem with being a global power is that all political
and military actions in one part of the world have repercussions in other parts of the world and unintended
consequences like blowback in the future. This calls for a subtle and flexible set of
foreign policies. Adapting to changing
circumstances and recognizing sometimes there are limited options is
crucial. Relying on an outdated set of
circumstances for an alliance with a rigid Saudi Arabian government limits
American options in the Middle East.
American foreign policy makers should question the wisdom of basing
decisions in the Middle East on the geopolitical interests of a repressive
government with no important allies in the region.
UPDATE (January 17, 2016)
By executing a Shiite cleric, the Saudis are
playing a devious and dangerous game.
Saudi Arabia sees Shiite Iran as their main geopolitical threat and is
very nervous about the treaty between Iran and the major powers. By inflaming relations between Shia and Sunni
countries, the Saudis are making it more difficult for the U.S. to follow up on
the lifting of economic sanctions against Iran.
The Saudis do not want any détente between the U.S. and Iran, which
implies a more flexible U.S. relationship with Saudi Arabia. By executing the imam, the Saudis also hope
it is more likely that the Iranian hard-liners, who also don’t like the treaty,
will defeat the moderates in the current government in the upcoming elections.
If they denounce or reject the treaty, the U.S. is once more dependent
on Saudi Arabia as the foundation for its Middle East policy. Iran will then be forced to strengthen its
ties to Russia and China.
At the same time, the Saudis continue to flood
the global oil market, leading to even lower prices. The main target of this strategy is the U.S.
shale oil industry. The Saudis hope to
force the industry to drastically cut production because of heavy financial
losses. So far this hasn’t happened but
virtually the entire industry is losing money (negative cash flow). On the positive side for the Saudis, the U.S.
and global oil industry is cutting investment, implying less
production capacity in the near future. Lower prices is leading to investment by the U.S. shale producers in new technology to reduce extraction costs.
The Saudis seem to believe that the United
States government can mentally separate the Saudi’s geopolitical strategy from
the Saudi’s oil strategy. They may be
right.
Saudi Arabia had a sovereign wealth fund of about $700 billion at the beginning of 2014. Their government deficit is running at around $100 billion per year. Cost reductions are politically dangerous because over 80% of Saudis, directly or indirectly, receive their income from the government. The government runs large social welfare programs and subsidizes the cost of food, fuel and electricity. Over 80% of the country’s export revenue and government revenue come from oil exports. I would guess that the Saudi government will start to reconsider their oil export strategy sometime in the fourth quarter of this year.
