A Note on the Geopolitics of Oil

By



Saudi Oil Minister
BACKGROUND INFORMATION

Oil is measured in barrels.
A barrel is 42 gallons.

Total global daily production is around 96-97 million barrels/day.
Saudi Arabia, Russia and the United States all produce around 10 million barrels a day.  With their allies, these three countries account for close to 40% of global production.
Because of the improved technology of shale oil production, U.S. output has gone up almost 5 million barrels/day since 2008.

Currently, total global production is greater than total demand by somewhere between one and three million barrels/day.
There are record amounts of oil in storage.

A small percentage increase of supply over demand has led to a large decrease in price.

In the fall of 2014, a barrel of oil cost about $100/barrel.  Last month the price fell to around $30/barrel.  Since then, it has rallied to around $40/barrel.

THE ECONOMICS AND GEOPOLITICS OF OIL

The economies of seventeen countries critically depend on oil production and the price of exported oil.  Many others, like Brazil and Mexico, partly depends on oil exports.

It has been a year and a half since the price of oil began to fall.  Many countries are now in recession.  Government revenues, mostly dependent on oil sales, have fallen drastically and budgets are showing large deficits.  In some countries, including Venezuela and Nigeria, the situation is serious enough to threaten the stability of the country.

Given global inelastic demand, a small percent decrease in global supply, around 3%, would lead to a large increase in price, probably around 60-100%.  All countries, including Saudi Arabia, would be economically better off.  Many other oil producers, but not Iran, have called for lower production.  So why hasn’t it happened?

Saudi Arabia and its Persian Gulf allies have had a number of objectives in pumping out a record level of oil and watching the drastic fall in price:
  •         Punish Iran, a Shia rival for power in the Persian Gulf and throughout the Arab world.  Saudi Arabia is Sunni.
  •         Punish Russia for supporting Iran and then Syria.
  •         Stop the growth of shale oil production in the United States.
  •         Drastically reduce the level of global capital investment in oil.
  •         Reduce production of high cost oil by making it unprofitable to continue production.
Two geopolitical changes in the last 18 months have hardened Saudi Arabia’s determination to produce record amounts of oil:

                    Lifting of economic sanctions against Iran
Saudi anger at the U.S. in supporting the end of sanctions.
          Russian military intervention supporting the Shia regime in Syria

Both events strengthened Saudi Arabia’s intentions of punishing Russia, the United States, and Iran by keeping production at record levels and prices low.  If Saudi Arabia and their Gulf allies agreed to reduce production and prices rose, the U.S., Iran, and Russia would benefit.

THE SAUDIS MISCALCULATE

The Saudis have not succeeded in meeting their goals as much or as quickly as they expected.  The overall strategy was to force other countries to cut back production of unprofitable oil and the Saudis and their allies would benefit from their high output and higher prices.

They miscalculated.  Like Saudi Arabia, most of the oil is pumped by government-owned or government-controlled companies.  They don’t care about profits, only revenue.  Government oil companies are a source of power, employment, patronage and corruption.  Except in the extreme where less revenue threatens the regime, these countries have no incentive to reduce output.  A substantial reduction will lead to higher market prices; other countries or companies will maintain or increase output.  Without widespread cooperation, the end result will be the same total output and the same low prices, except the countries that reduced output will lose market share and end up with even less revenue.

The only hope is that major producers, both OPEC and non-OPEC, can get together and agree to a collective reduction in production.  A meeting is scheduled in Qatar on April 17.  Saudi Arabia and Russia say they will attend the meeting; U.S. oil companies probably won’t. 

Iran won’t attend and says it will increase production regardless of what other producers do.  They have softened their position by recently saying that if they are allowed to increase production to some unspecified level, they will stop any further increase in production.

What changed?  Why is Saudi Arabia signaling it might reduce output?
Internal pressures.  Fragile society with suppressed tensions.  Kept together by a huge social welfare system financed by oil revenue.  The Saudi government is running a large budget deficit which is rapidly reducing its sovereign wealth fund that finances the lost revenue.

Saudi would be the “last man standing” but it might be a Pyrrhic victory.  The price might be too high.

The Russian economy is really hurting.  A continuation of low prices for oil and natural gas could eventually threaten Putin’s power.
Clear signal to Saudis that they want, or need, an end to low prices.  Given the continuing economic pain at home, Putin appears willing to cooperate with Saudi Arabia - the geopolitical rival of its client states in the Middle East - in exchange for a stable domestic economy and increased government revenues at home.

A third miscalculation.  U.S. shale production hasn’t gone down anywhere near as much or as fast as the Saudis expected.  Two reasons:
Private companies look to marginal costs and shutdown expenses, not average cost, in deciding whether to continue production.  Reacting to low prices, they have lowered their costs and reduced their losses. American drillers adapted to lower prices by shutting down low-producing wells, using new technology to increase output per well, reducing drilling costs by drilling deeper and faster with fewer workers, and forcing suppliers to reduce their prices to producers.

Until first quarter of 2016, many oil producers had locked in higher selling prices through futures contracts.

American oil executives are saying that in the better shale oil areas, new wells can be profitable at $30/barrel.  Oil experts believe that at $45-$50/barrel, total U.S. shale production will stop falling.  Above $50/barrel, U.S. shale oil production will increase again. 

Some countries may not cut production as promised.  U.S. shale producers can offset a reduction in total supply.  In that sense, the U.S., not Saudi Arabia, has become the swing producer.

Both U.S. and global inventory are at record levels.  Even if production falls three million barrels a day, inventory drawdowns can make up most or all of the decrease.  Total supply would remain at current high levels and prices would fall again.

THE RECENT PRICE INCREASE

The futures market and speculators have driven the price of oil from around $30/barrel to $40/barrel.  Little has changed from the underlying supply/demand balance that drove the price from $100/barrel to $30/barrel.  Why the increase?

Speculators look ahead.  Like gamblers at a roulette wheel, they pick a number and “puts down their money and takes their chances.”   They are betting that the major oil producers have reached the panic point and will agree to reduce production on April 17.  They are also covering short positions  These actions increased the world price of oil.  But, as the above comments indicate, only temporarily.

 THE UNITED STATES:  NAFTA IS THE NEW OPEC

 The United States is poised to become the world's largest producer of oil and possibly  the world's largest exporter of refined oil products. Combined with a fall in domestic demand for refined oil products because of electric and hybrid vehicles, the United States could become a net exporter. All of America's remaining import needs could be filled by Canada and Mexico. Already, the United States does not need any Middle East oil. One reason for past American involvement in the Middle East no longer exists. The main economic reason for an alliance with Saudi Arabia no longer exists.

 The United States controls the technology of shale production. This technology is vital to opening new fields and recovering residual oil in old fields. It is also a geopolitical weapon. Currently, U.S. sanctions against Russia includes withholding oil drilling technology. 

Related, the United States is already self-sufficient in natural gas, exporting to Mexico, and building liquid natural gas (LNG) plants for export. To reduce dependence on Russia, Poland and Lithuania are building LNG receiving plants. Poland is considering a pipeline from its LNG plant to Ukraine. The United States, plus new natural gas finds in the Mediterranean and shale fields in Poland and Ukraine, could replace much of the Russian exports to Europe.   

CONCLUSION 

The geopolitics of oil complicates the economics of oil. Inelastic demand for oil implies that a small percentage decrease in output will lead to a large percentage increase in price and revenue. But geopolitical rivalries make cooperation difficult and probably temporary.  Some of these rivalries have an overlay of intense religious or historical animosity. Virtually every OPEC member has a history of cheating on production quotas. And now any reduction agreement can be countered by increased output in the United States, Canada, and Mexico.

 Oil prices are the result of a complicated interaction of political and economic factors.  Oil buys power and influence.  Saudi Arabia is betting that they can use their oil policy to reassert some control over the tangled conflicts in the Middle East.  Russia hopes that oil and natural gas exports will fuel domestic political stability and geopolitical ambitions. Oil and natural gas exports to Europe are Russia's most effective foreign policy weapons. Ironically, both countries’ ambitions are at the mercy of increased output and technological improvements in American shale oil production.

 =========================================================

For further reading, see

http://bennettgreenberg.blogspot.com/2015/11/saudi-arabia-oil-and-geopolitics.html

http://bennettgreenberg.blogspot.com/2015/09/energy-and-geopolitics-ii-world-ex.html

http://bennettgreenberg.blogspot.com/2015/09/energy-and-geopolitics-i-united-states.html

http://bennettgreenberg.blogspot.com/2015/04/the-russian-economy-and-geopolitics-of.html

http://bennettgreenberg.blogspot.com/2015/04/the-death-of-opec-sheikh-rattle-and-roil.html

http://bennettgreenberg.blogspot.com/2015/01/changing-oil-prices-different.html

http://bennettgreenberg.blogspot.com/2014/12/cheaper-oil-winners-and-losers.html

For excellent ongoing analysis of the geopolitics and economics of the global and national oil markets, see http://oilprice.com.

The classic book on the history of the global oil industry and the rise of OPEC is Daniel Yergin, The Prize.





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