Op-ed: What Analysts Get wrong about #Saudi Oil Policy
By Omar Al-Ubaydli
After Russia’s withdrawal from #OPEC+ and the sharp fall in oil prices, many analysts have framed the scenario as a head-to-head battle between Russia and Saudi Arabia. This line of thinking is erroneous; in the coming months, it is unlikely that Saudi Arabia and OPEC will cut output independently of Russia. Moreover, there will be no “victor;” it will merely be business as usual for a competitive market.
Henceforth, there are three possible production scenarios: (1) everybody producing in a manner that maximizes profits, known as a competitive market; (2) an OPEC-only coordinated output cut, with OPEC non-members maximizing profits; (3) an OPEC+ coordinated output cut.
In terms of economic theory, Saudi Arabia will likely earn the highest profits under scenario (3), followed by scenario (1). The least profitable scenario for it is an OPEC-only (or even worse, a Saudi Arabia only) coordinated output cut. That’s because OPEC accounts for around 44 percent of global oil production, which is far too little for a coordinated output cut to be profitable. In particular, shale oil production is highly flexible and responsive to market conditions, and so if OPEC takes barrels off the market and prices rise a little, shale oil simply expands in a matter of weeks to fill the void.
Thus, the first error by oil analysts is thinking that an OPEC-only coordinated output cut is more profitable for Saudi Arabia than competitive production. Because of this, they incorrectly perceive Saudi Arabia’s output expansion as an attempt to “punish” Russia even if it is painful for the Kingdom, leading to the red herring of a Russia versus Saudi Arabia price war. It is possible that Saudi Arabia is looking to produce close to or even slightly above capacity, but this is more likely driven by a desire to take advantage of oil prices while they are still high, and to run down some accumulated inventories.
Longer-term, Saudi Arabia just wants to produce at capacity in the same way that producers of copper, cars and laptops try to produce at capacity. You should be no more surprised to hear that Saudi Arabia is declining a unilateral output cut than you are to hear that Chile, Toyota or Samsung are declining one: unless most producers join in, you lose money.
If coordinated output cuts need the participation of all of OPEC+ to be profitable, does that mean that for the 40 years prior to 2016, OPEC was inadvertently effecting unprofitable coordinated output cuts?
University of Brown professor Jeff Colgan looked at data from 1980 to 2009 and found a clear answer to this question: with the exception of Saudi Arabia, nobody in OPEC was cutting output (the quota compliance rate was 4 percent). And that’s not surprising at all since cartels are incredibly hard to operate under the best conditions, which are a small number of geographically close producers who dominate production and operate in a market with stable demand. Oil markets are the exact opposite: a large number of producers that do not dominate production and that operate in a market with unstable demand!
Colgan did find that Saudi Arabia persistently produced below capacity. This was an attempt to curry favor with the US and other western countries: in the pre-shale era, supply disruptions, such as the invasion of Kuwait, would cause price spikes, hurting advanced economies. By maintaining spare capacity, Saudi Arabia could compensate for supply disruptions, stabilizing global prices. Thus, the Kingdom consciously sacrificed oil-based profits in the pursuit of broader strategic benefits.
The arrangement changed in 2014 because of two developments. First, US-Saudi relations deteriorated under Barrack Obama. Second, shale oil’s ability to rapidly increase output meant that there was no more value in Saudi Arabia being able to plug a supply hole. Former oil minister Ali Al-Naimi correctly switched to making production decisions on a commercial basis only, and Prince Abdulaziz bin Salman is continuing that. The interregnum under OPEC+ was the exception because it involved a larger gross market share.
But maybe OPEC+ wasn’t a profitable departure from competitive production for all parties, due to shale oil’s ability to steal market share. Thus, it could be that the Russo-Saudi disagreement is merely a reflection of different assessments about how profitable OPEC+ is compared to competitive production. The fact that Saudi Arabia has lower production costs than Russia could explain why Saudis prefer OPEC+ to competition, while Russia prefers competition to OPEC+. Or it could be due to diverging plausible assessments on the future of shale.
Oil-market behavior is notoriously hard to forecast, especially due to the commodity’s strategic importance. But expecting Saudi Arabia to lead an output cut without two of the world’s three largest oil producers is expecting it to commit commercial suicide. Don’t be surprised if Saudi Arabia and Russia do nothing more than quietly produce at capacity, as that’s what happens almost all the time in virtually every product market. Oil may finally be about to become boring.
*Omar Al-Ubaydli (@omareconomics) is an economist at George Mason University.