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US Foreign Policy (Dr. El-Najjar's Articles)
Saudi Oil Strategy: Brilliant Or Suicide?
By Dalan McEndree
Price, Al-Jazeerah, CCUN, August , 2015
In the last quarter of 2014, in the face of possible oversupply, Saudi
Arabia abandoned its traditional role as the global oil market's swing
producer and therefore it role as unofficial guarantor of existing ($100+
per barrel) prices.
In October, Saudi sources first prepared the
market with statements that the country would be comfortable with oil
prices as low as $80 per barrel for "a year or two." At the November OPEC
meeting, the Saudi oil minister, Ali Al-Naimi, publicly announced Saudi
Arabia would allow market forces to set prices. He argued that rapidly
growing production outside OPEC made the existing status quo unviable, and
that lower prices in the short term would increase prices in the longer
term through reduced investment and ultimately benefit all OPEC members.
Parallel with this shift, Saudi officials expressed confidence in
their country's financial wherewithal to withstand the repercussions of
lower oil prices.
The Saudis Expected a Hole, Not a Bottomless Pit
The Saudis obviously miscalculated the degree to which their shift
would negatively impact oil prices. The average price of Brent, the global
benchmark, fell below the Saudis' $80 floor in November, fell to $62.34 in
December, then fell below $50 in February. Prices rebounded to $60 for a
few months, before falling once again below $50.
prices have substantially reduced Saudi revenues. With Brent prices
averaging roughly $100 per barrel in 2014, Saudi oil exports of 6.31
million barrels per day would have generated roughly $631 million in
revenues daily. In the first quarter, with Brent prices averaging $53.92,
the same output would have generated roughly $340 million daily, $291
million less per day than oil at $100 per barrel.
The Saudis have
attempted to mitigate the revenue shortfall through increased production,
ramping up output from 9.6 million barrels per day in the fourth
quarter of 2014 to an eye-popping 10.5 million barrels per day in June.
The revenue from increased production, however, is overwhelmed by
the collapse of prices, which has ripped a substantial hole in the Saudi
budget. In December 2014, the Saudi government
approved spending $229 billion in 2015, resulting in an estimated
deficit of $39 billion, or some 5 percent of GDP.
As mid-year 2015
approached, the IMF
estimated the budget deficit would equal approximately 20 percent of
Saudi GDP. The Financial Times quoted analysts as
estimating the Saudi budget deficit in 2015 at $130 billion. Even with
massive deficit spending, the IMF estimated GDP growth would slow from 3.6
percent in 2014 to 3.3 percent in 2015, and then just 2.7 percent in 2016.
Racing to Barrel Oil
The Saudi miscalculation has several
sources. One is the negative feedback loop between oil production, GDP,
and national budgets that plagues many non-Western oil producers. Their
GDP and national budgets depend significantly on the revenues from their
oil exports. As a result, the revenue shortfalls incentivize them to
produce as much oil as possible to mitigate the shortfall.
According to the IEA, daily output in June 2015 increased 3.1 million
barrels over 2014, with 60 percent (1.8 million barrels) coming from OPEC.
At 31.7 million barrels per day, OPEC output reached a three-year high.
This increase in output occurs with the context of a narrow global
demand opportunity. Growth in demand in 2015, which the IEA
average around 1.4 million barrels per day, comes primarily from Asia and
North America. In other major export markets, demand is stagnant. That has
oil exporting countries, including OPEC members, Russia and others,
focusing their sales on Asia, particularly China. North American
demand is growing now that oil prices are low, but due to high levels of
domestic production, the U.S. is no longer a growth market for oil
Each producer, therefore, is incentivized to undercut
other producers directly (price per barrel) or indirectly (absorbing
shipping cost or delivery risk) to win sales in Asia (or displace
incumbent suppliers in other major markets). National oil producers can
and are shifting the cost of the lowered prices to other sectors of the
economy. The U.A.E., for example, has ended fuel subsidies, thereby
essentially, increasing its budget revenues, while Saudi Arabia recently
floated a $4 billion domestic bond offering to help finance its budget.
Asian customers are taking advantage of the competition. They are
reducing the share of long-term contracts in favor of spot purchases. For
example, as the Wall Street Journal
reported, some Japanese refiners are cutting the proportion of oil
purchased through long-term contracts to around 70 percent from more than
90 percent, while some South Korean refiners are reducing the proportion
from 75 to 50 percent. Furthermore, several national oil companies,
Venezuela's among them, are building refineries with local partners in
Asia, which will use their crude.
Given this environment, it is
not surprising that the revenue elasticity of production is highly
sensitive, and negative. Saudi Arabia increased production by 6.8 percent
in the first quarter of 2015 but saw export revenues shrink by 42 percent.
Any Saudi Victory Will Be Pyrrhic
Saudi confidence in
their financial wherewithal is proving misplaced. Their need for revenue
is intensifying rather than moderating. They are fighting a multi-front
war with Iran directly (in Yemen) and indirectly (in Syria, Lebanon, and
Iraq). ISIS, Al Qaeda, and disaffected Shias present a significant
domestic security threat. Countering external and internal threats demands
increased spending (including, perhaps, a very expensive future nuclear
weapons program), as does placating the fast growing male and female youth
demographic, which requires substantial spending on education, training,
employment, and support. Hence, the budget deficit equal to 20 percent of
GDP, noted above.
Increased production does not offer a solution.
Saudi Arabia doesn't have
the capacity to increase production sufficiently to reduce the
shortfall significantly in any meaningful timeframe. They currently do not
have the spare capacity—to make up for the $291 million in export revenue
lost in Q1, 5.4 million more barrels a day would have been necessary at
$53.92 a barrel. Of course, such a drastic increase in output would have
driven prices even lower.
It is doubtful they can increase
capacity substantially even in the medium- to long term. They won't be
able to spend significantly more than other major national oil companies.
First, low prices reduce Aramco's cash flow and therefore its ability to
fund investment. Second, the Saudi government likely will increase its
draw from this cash flow to fund higher priority national security and
domestic security needs.
Third, Saudi refusal to act as price
guarantor undercuts the confidence foreigners need to invest in, or loan
to, oil projects. What might be attractive at $75 per barrel oil isn't at
$50 oil, and even less attractive if the price of oil is thoroughly
unpredictable. Fourth, in terms of political risk, Saudi Arabia with its
Gulf allies, Iran, and Iraq, and the Middle East in general, is at the
epicenter of global tension, turmoil, and tumult. Fifth, its influence
within OPEC, and therefore its ability to manage OPEC output and prices,
is diminished. Their underestimate of the impact of their policy change on
prices, their indifference vis-ŕ-vis the financial damage to other OPEC
members, and their willingness to take market share at the expense of
other OPEC members undercut their credibility within OPEC (particularly
since it derived from Saudi willingness to protect the interests of all
members (and sometimes to endure disproportionately).
financial reserves are substantial (circa
$672 billion in May), drawing on them is little more than a stop-gap
measure. If its major competitors (Russia, Iraq, Iran, and North America)
maintain or even increase output (and they have the incentive to do so),
prices could stay lower far longer than the Saudis anticipated. Saudi
reserves have decreased some $65 billion since prices started to fall (in
November), so ~$100 billion to ~$130 billion at an annual rate. The longer
prices stay low, the faster their reserves fall, and, as reserves plummet,
the greater the pressure to prioritize spending, to the disadvantage of
Saudi Arabia Caused The Problem, Can It Engineer A
Saudi officials apparently viewed $90 or even $80 per
barrel oil for "one or two years" with equanimity. Can they maintain the
composure they have displayed thus far as they incur in a single year the
revenue losses they expected to take four years (at $90 oil) or two years
(at $80 oil)?
And if they can't—and surely, though they are loath
to admit it, they can't—can they engineer a durable increase in
prices—i.e., a durable decrease in output? At first glance, it seems
Daily output from Saudi Arabia (10.5 million), and its allies, UAE
(2.87), Kuwait (2.8), and Qatar (.67), is roughly equal to the daily
output from countries with which it is in conflict, directly or
indirectly, Russia (11.2), Iran (2.88), and Iraq (3.75), and therefore
have an incentive to take advantage of any unilateral Saudi output
Yet, in effect, these countries are engaged in the
oil equivalent of mutually assured destruction. The sharp drop in oil
revenue damages each of these countries economically and financially,
while the wars they wage directly and indirectly against each other drain
resources from vital domestic projects.
Moreover, given the
sensitivity of prices to changes in volume, it is possible, if not likely,
that holding output steady or matching a Saudi decrease barrel for barrel
could generate an absolute increase in revenues for all.
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