The Marginal (Opportunity) Cost of Saudi Arabian Oil

 

To an economist, the word “cost” implicitly has the word “opportunity” in front of it.  Not knowing the difference between accounting cost and opportunity cost can lead to some serious pricing mistakes and misallocation of resources.

Saudi Arabia is one of the world’s three large crude oil producers, pumping over 10 million barrels per day. (A barrel is 42 gallons.) About 2.5 million barrels per day are refined for domestic consumption. Consumption of domestic oil has been rising rapidly.

Saudi Arabia is the world’s most inefficient user of oil. The country subsidizes the price of gasoline and electricity. It has the world’s highest oil consumption per capita. Besides fuel, oil is used to generate electricity and desalinize water. It has been common for families to leave their air conditioning on even when going on vacation. Some offices are so cold that employees wear sweaters. 

Prices to consumers are low because of low crude oil production costs and the large government subsidies. Saudi Arabia is probably the world’s low cost producer of crude oil. Marginal cost is in the $5-$10 per barrel range. This low cost is passed on to refineries that produce gasoline, fuel for industry, and electricity. They, in turn, charge their customers a low price. In addition, the Saudi government spends over $10 billion/year to subsidize the cost to consumers of gasoline and diesel. Saudi drivers until 2015 paid the lowest price in the world for gasoline. The prices to consumers for electricity and water are also subsidized. The funds for these subsidies come from oil export revenue.

As domestic demand for oil products has risen, so has refining and power generating capacity. Saudi Arabia has increased production capacity by completing a $100 billion modernization and expansion of their oil infrastructure. Exports have remained constant. 

For years, until 2015, the world price for crude oil was around $100/barrel. The high price of oil paid for the domestic subsidies.

For Saudi Arabia, $100/barrel was the opportunity cost of oil. Every barrel sold to domestic refineries at $10/barrel could have been sold to foreign refineries at $100/barrel. Domestic prices were based on the accounting cost of crude oil, not the opportunity cost.

If domestic prices had been based on the world price of oil, Saudi Arabia would have experienced the same effects as other countries. Growth in consumption would have been lower. There would have been an incentive to use oil more efficiently. Toyotas for Range Rovers. New technology and conservation would have appeared. Saudi Arabia is a country that could benefit from solar and wind generation of power.

The irony is that Saudi Arabia began moving in these new directions only when the opportunity cost of oil went down, when the world price of oil fell to $30-$50/barrel starting in 2015. Government revenue, over 80% dependent on export sales, fell. The government budget went from showing large surpluses to running large deficits. The government’s reserve fund was being depleted. New political leaders want to cut spending by reducing subsidies.

The government is beginning to look for alternative strategies to the burning of high (opportunity) cost oil. Investments in solar and wind have been announced. Natural gas is being substituted for oil. The prices of refined oil products and electricity are being raised. The price of gasoline, which was $0.48/gallon before an increase in 2015, rose again in 2017 to $1.35/gallon. More oil will be available to sell when the export price of oil goes up.

If you are interested about how the fall in oil prices affected the geopolitics of the Middle East and American shale production, see Saudi Arabia, Oil and Geopolitics.