Saudi Arabia, Oil and Geopolitics

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.