World Oil Prices: Market Expectations, the House of Saud, and the Transient Effect of Supply Disruptions

By Benjamin Zycher June 2016

KEY POINTS

• The common argument that the sharp decline in oil prices during 2014–15 inevitably will lead to another steep increase is largely unsupported by the data on current and futures prices. • The House of Saud may perceive an increased need to buy internal political support, and even a rising threat of overthrow from opponents internal or external, which would increase incentives for lower prices and increased output in the near term. • The recent moderate upturn in prices is consistent with the data showing increases in supply disruptions, but both economic analysis and the historical evidence suggest that the price effects of important supply disruptions tend to dissipate quickly.

everal observers have argued that the recent sharp of spot prices and rates of return to arbitrage activities Sdecline in oil prices is unlikely to last, largely does not support that conclusion. because pricing strategy by Saudi Arabia can be Observed Saudi production and pricing strategy is described as “dynamic profit maximization” designed consistent with a different hypothesis: the House of to drive overseas competitors out of business in the Saud’s increased fears of internal and external threats short run, and to erode investment in new competitive to its rule, and an increased possibility of some sort of production capacity over the longer term. Punishment overthrow. In addition, the more recent partial recov- of overseas competitors unquestionably is a component ery of international oil prices is consistent with an of Saudi strategy, but the ensuing conclusion that sharp observed increase in global supply disruptions, so that price increases are to be expected does not follow. That a longer-term price recovery might reflect that factor model falls short as economic analysis because it asks rather than the effects of dynamic profit maximization the wrong question: Will future oil prices remain low? by the Saudis. At the same time, a simple simulation of The correct question is much more difficult: Why are a severe supply disruption suggests that market prices current prices not far higher already? would decline quickly from an initial sharp increase, an A sensible model of oil price patterns over time pre- inference supported by the long-run history of move- dicts that expectations of higher future prices should ments in oil prices. be reflected in current prices. Current prices do not Some common dimensions of conventional wisdom on suggest sharply higher price trends, and recent data on international oil markets—in particular, the description futures prices and consumption and production paths of OPEC as a cartel and the assumed effects of the 1973 are consistent with that inference. Although recent Arab OPEC oil embargo—are incorrect. But the optimi- movements in crude-oil inventories support an infer- zation problem faced by the House of Saud is complex ence of prospective price increases, a simple analysis

AMERICAN ENTERPRISE INSTITUTE 1 and fascinating, an observation that supports the larger The additional argument made by some that Saudi cash truth that specialists in economics and in the interna- reserves of about $600 billion6 allow them to “ride tional politics and the defense dynamics of the Middle out” periods of low prices more easily than others is, East have much to learn from each other. however, problematic: Unlike a typical US oil producer, the House of Saud confronts threats to its rule—large, growing, long-term, and both domestic and foreign, I. Background about which more below.7 Accordingly, vast spending My colleague Kevin A. Hassett offered recently a short to ameliorate them is necessary but may not be sustain- and informal analysis of prospective oil prices, argu- able.8 The International Monetary Fund, for example, ing that Saudi pricing policy is intended in substantial estimated in 2015 the Saudi “fiscal gap” at about 20 part to make competitors’ investments in production percent of “non-oil GDP,” a parameter that analytically capacity unprofitable over the longer term.1 That is is questionable (an issue for another day), but likely to consistent with a related dimension of Saudi produc- be correlated with the fiscal ability of the ruling family tion policy, intended ostensibly to preserve “market to maintain social spending deemed necessary.9 Note share,” which actually is designed to allow greater the recent news reports that the House of Saud now is volatility in oil prices so as to increase investment risks issuing bonds as vehicles for borrowing in international perceived by competitors.2 Over the longer term, both capital markets.10 impacts would reduce worldwide production capacity What is important here is the political reality that and increase prices below and above the respective the large nominal size of Saudi cash reserves is less 3 levels that would prevail otherwise. Thus the Saudis impressive than may seem to be the case in the context maximize profits dynamically by driving prices down of low oil prices. From the perspective of straightfor- to levels at which it is unprofitable for others to invest, ward economic analysis, low marginal production costs for example, in new hydraulic fracturing production facilities. 6 See International Monetary Fund, “Saudi Arabia: Inter- It is correct to note as well that Arab OPEC producers national Reserves and Foreign Currency Liquidity,” https:// enjoy marginal production costs lower than those in www.imf.org/external/np/sta/ir/IRProcessWeb/data/sau/ the US and elsewhere;4 accordingly, the Saudis and the eng/cursau.htm. other Persian Gulf producers can continue production 7 See David P. Goldman, “Saudi Arabia Stews in Policy profitably during periods of low prices while other Hell: Spengler,” Asia Times, January 3, 2016, http://atimes. com/2016/01/saudi-arabia-in-policy-hell/; Simon Hender- producers cannot, as illustrated by the current wave of son, “The Reality of Riyadh,” Washington Institute for Near 5 bankruptcies in the US oil patch. East Policy, February 16, 2016, http://www.washingtoninstitute.org/policy-analysis/view/the-reality-of-riyadh; and Yoel Guzansky, “Saudi Arabia: A Buildup of Internal and External Challenges,” Institute for National Security Studies Insight No. 768, November 18, 2015, http://www.inss.org.il/index. 1 Kevin A. Hassett, “Don’t Stop Worrying About Oil,” aspx?id=4538&articleid=10937. National Review, February 29, 2016, http://www.aei.org/ publication/dont-stop-worrying-about-oil/. 8 See Kate Drew, “Saudi Arabia’s Big Welfare Spending Faces the Oil Abyss,” CNBC, December 3, 2015, http://www. 2 See Roberto A. De Santis, “Crude Oil Price Fluctuations cnbc.com/2015/12/03/biggest-cash-issue-for-saudi-arabia- and Saudi Arabia’s Behavior,” Energy Economics 25, no. 2 goes-beyond-oil.html; US-Saudi Arabian Business Council, (March 2003): 155–173, http://www.sciencedirect.com/ “Saudi Arabia’s 2015 Budget Maintains Strong Spending, science/article/pii/S0140988302001068. Diversification Initiatives,” 2015,https://www.us-sabc. 3 Recent news reports suggest that this effect is being org/custom/news/details.cfm?id=1645; David P. Goldman, observed among non-OPEC producers of crude oil. For exam- “Cheap Oil Puts the House of Saud at Risk,” Asia Times, Octo- ple, see Benoit Faucon, “OPEC Sees Sharper-Than-Expected ber 22, 2015, http://www.meforum.org/5582/saudis-cheap- Fall in Non-Cartel Output,” Wall Street Journal, April 13, oil; and Sultan Sooud Al Qassemi, “The Gulf’s New Social 2016, http://www.wsj.com/articles/opec-sees-sharper-than- Contract,” Middle East Institute, February 8, 2016, http:// expected-fall-in-oil-output-outside-the-cartel-1460543249. www.mei.edu/content/article/gulfs-new-social-contract. 4 For the reported marginal cost data, see Koema, “Cost of 9 International Monetary Fund, Regional Economic Outlook: Oil Production by Country,” http://knoema.com/vyronoe/ Middle East and Central Asia, October 2015, p. 67, Figure 4.3, cost-of-oil-production-by-country. See also Rystad Energy, http://www.imf.org/external/pubs/ft/reo/2015/mcd/eng/ “Overview,” http://www.rystadenergy.com/Products/ pdf/menap1015.pdf. EnP-Solutions/UCube/Default. 10 See Simeon Kerr and Elaine Moore, “Saudi Arabia Takes 5 Matt Egan, “U.S. Oil Bankruptcies Spike 379%,” CNN Out $10bn in Bank Loans,” CNBC, April 19, 2016, http:// Money, February 11, 2016, http://money.cnn.com/2016/02/ www.cnbc.com/2016/04/19/saudi-arabia-takes-out-10bn-in- 11/investing/oil-prices-bankruptcies-spike/. bank-loans.html.

AMERICAN ENTERPRISE INSTITUTE 2 mean that maximization of sales revenues is a useful II. Some Data approximation of maximization of profits as a rough guideline for predicting Saudi output and pricing poli- In brief, Hassett concludes that the low prices13 of cy.11 It is axiomatic that any given producer, including about $30 per barrel observed at the time that he wrote the Saudis, faces “elastic” demand (a reduction in price his article are unlikely to last because dynamic profit yields an increase in total sales revenue), particularly in maximization by the Saudis—allowing low prices to a global commodity market such as that for crude oil. drive production by current competitors downward and to discourage investment by future competitors— Therefore, if maximization of sales revenues is a useful means that the current price is lower than the long-run approximation of Saudi objectives, then prices lower equilibrium price, perhaps by a substantial amount: rather than higher—a bigger market share—are con- “Today’s low prices probably mean higher long-run sistent with that goal. Such lower prices certainly are profits for OPEC, higher prices at the pump, and a consistent with the goal of driving competitors out of share of world production for OPEC that is for the most business, and thus with higher prices over the longer part steady. Sorry.”14 term, but all producers with low marginal production costs will have incentives to compete those higher Prices indeed have increased substantially this year prices downward. This includes producers with low since the January/February period, from $27.88 per costs of ceasing production when prices are low and barrel (for Brent crude oil) on January 20 to $45.93 on of resuming operations when prices rise. Moreover, April 21, or 65 percent. Figure 1 shows this recent trend the higher long-term prices inexorably will engender with the daily data for Brent spot prices, for January investments in technological advances—the US revo- 4 through April 21.15 (The gaps are days when the lution in hydraulic fracturing and horizontal drilling markets were closed.) Notwithstanding the volatility is the most obvious recent example—so that a predic- in given weeks, the upward trend from mid-January tion of prices substantially higher than those observed through mid-April is clear, with hiatuses in parts of recently is not obviously correct, a point discussed in February and March. 12 Section II. Section III presents observations on the Whether this is part of the longer-run price increase growing internal and external threats faced by the that Hassett and others predict16 or simply a manifes- House of Saud. Section IV presents a simulation of tation of familiar short-run volatility in crude prices the price effects of a severe oil supply disruption over remains to be seen, but some basic analytics can be a 10-year horizon. Section V offers a brief criticism of applied to this question. First, the production and con- two central components of conventional wisdom on the sumption of oil are substitutable over time; a given bar- history of the international oil market, and Section VI rel can be produced and/or consumed during either the presents concluding observations. current time period or some future one. This means— under a complex set of simplifying assumptions—that the profitability of (i.e., the total expected economic return to) producing and selling a barrel of oil today must equal the expected profitability of producing and 11 In the conceptual case in which marginal production selling it in the future.17 cost is zero, a profit-maximizing producer would choose an output level at which total sales revenues are maximized, that is, where marginal revenue (which normally declines more 13 See Oil-price.net, “Crude Oil and Commodity Prices,” rapidly than price as the latter falls) is zero. When marginal http://www.oil-price.net/. cost is low (but still greater than zero), maximization of total 14 Hassett, “Don’t Stop Worrying About Oil.” sales revenue is a useful approximation of profit maximization at the point where marginal revenue equals marginal 15 See Investing.com, “Brent Oil Historical Data.” cost. It is useful because measurement of marginal cost often 16 For example, see Kamal Ahmed, “BP Boss: Oil Price Will is difficult. Rise,” BBC News, January 20, 2016, http://www.bbc.com/ 12 For useful summary descriptions of hydraulic fracturing news/business-35363066; and Brad Beago, “Why Oil Prices and horizontal drilling, see Independent Petroleum Associ- Will Rise and Many Pundits Will Be Caught by Surprise,” ation of America, “Hydraulic Fracturing: Effects on Energy OilPrice.com, April 5, 2016, http://oilprice.com/Energy/Oil- Supply, the Economy, and the Environment,” April 2008, Prices/Why-Oil-Prices-Will-Rise-And-Many-Pundits-Will- http://energyindepth.org/docs/pdf/Hydraulic-Fractur- Be-Caught-By-Surprise.html. ing-3-E’s.pdf; and Geology.com, “Directional and Horizontal 17 If it were more profitable to sell a barrel of oil today than Drilling in Oil and Gas Wells,” http://geology.com/articles/ to hold it for sale tomorrow, more oil would be sold today, horizontal-drilling/. For historical data on international oil reducing its price and thus the profitability of selling it in the prices, see Investing.com, “Brent Oil Historical Data,” http:// current time period. The analysis is identical for the case in www.investing.com/commodities/brent-oil-historical-data. which the expected profitability of selling in the next time

AMERICAN ENTERPRISE INSTITUTE 3 Figure 1. Brent Daily Spot Prices

US Dollars per Barrel 15

0 Apr 1 Apr 5 Apr 9 Jan 4 Jan 8 Mar 4 Mar 8 Feb 1 Feb 5 Feb 9 Apr 13 Apr 17 Apr 21 Jan 12 Jan 16 Jan 20 Jan 24 Jan 28 Mar 12 Mar 16 Mar 20 Mar 24 Mar 28 Feb 13 Feb 17 Feb 21 Feb 25 Feb 29

2016 Date

Source: Investing.com, “Brent Oil Historical Data,” http://www.investing.com/commodities/brent-oil-historical-data.

For our purposes here, the current and expected future expected to have increased by more than 4 percent, prices of oil are reasonable first approximations of the thus earning a return greater than the market rate of parameters yielding those “total economic returns,” interest.19 Accordingly, if prices are expected to rise at or profitability. Suppose that the risk-adjusted mar- a rate higher than the interest rate, less oil will be pro- ket rate of interest in the private sector is 4 percent.18 duced today, raising the current price, and more oil will An oil producer can produce a barrel today, put the (be expected to) be produced in the future, reducing proceeds in, say, corporate bonds, and expect to earn the expected future price. This adjustment continues 4 percent. If oil prices are expected to rise at a rate until the profitability of producing and selling oil today higher than 4 percent, then there is created an incen- equals the expected profitability of doing so tomorrow, tive to keep oil in the ground, selling when prices are 19 As an aside, one implication of such standard analysis is as follows: Expectations that the Federal Reserve will increase period is higher. See Harold Hotelling, “The Economics of US interest rates should put downward pressure on current Exhaustible Resources,” Journal of Political Economy 39, oil prices in dollars because whatever the expected future no. 2 (April 1931): 137–175, http://msl1.mit.edu/classes/ price of oil, the current price must be lower in order to rise at esd123/2003/bottles/Hotelling.pdf; Tim Haab, “Env-Econ that higher rate of interest. It is interesting, therefore, that the 101: Hotelling’s Rule Part 1,” December 5, 2013, http://www. Fed statement on March 16, 2016, softening its earlier stance env-econ.net/2013/12/env-econ-101-hotellings-rule-.html; on a gradual increase in the federal funds rate, coincided with Tim Haab, “Env-Econ 101: Hotelling’s Rule Part 2,” Environ- an increase in oil prices of more than 7 percent over March mental Economics, December 6, 2013, http://www.env-econ. 16–17. See Board of Governors of the Federal Reserve System, net/2013/12/env-econ-101-hotellings-rule-part-2.html; press releases, March 16, 2016, https://www.federalreserve. and James D. Hamilton, “Understanding Crude Oil Prices,” gov/newsevents/press/monetary/20160316a.htm, and Energy Journal 30, no. 2 (2009), pp. 179–206, http:// December 16, 2015, https://www.federalreserve.gov/ econweb.ucsd.edu/~jhamilton/understand_oil.pdf. newsevents/press/monetary/20151216a.htm, respectively. 18 For the data on interest rates, see Council of Economic Has the market anticipated this Fed softening since mid- Advisers, “Economic Indicators,” March 2016, p. 30, https:// January? It is hard to measure expectations or to discern the www.gpo.gov/fdsys/pkg/ECONI-2016-03/pdf/ECONI-2016-03.pdf. factors that drive them.

AMERICAN ENTERPRISE INSTITUTE 4 restoring the slope of the expected price path to the think that the market ought to be able to predict the market rate of interest. The same analysis applies if oil approximate effects on investment and future prices prices are expected to fall: Producers will increase out- attendant upon Saudi pricing strategy.23 Accordingly, put today in order to take advantage of current prices current prices would reflect expectations of the higher higher than expected future ones, thus reducing prices future prices predicted by that analysis. Figure 2 today and increasing expected ones in the future. The illustrates recent paths for crude oil prices (in nominal expected price—not necessarily the actual price, as new dollars) and global production and consumption, using information emerges constantly—rises at the market monthly (not daily) data from January 2014 through rate of interest. March 2016.24 As an aside, this standard analysis is inconsistent with Production has increased over this period from about the commonly asserted “peak oil” hypothesis: Because 92 million barrels per day (mmbd) to about 96 mmbd, global oil reserves are (by assumption) finite physically, with most of the increase observed in 2014. Consump- a maximum extraction rate for oil will be reached at tion increased beginning around the middle of 2014 some point, after which that rate must decline perma- as prices fell, and then again in the summer of 2015 as nently.20 Apart from the future effects of new discov- prices fell further, by a total of about 3 mmbd. The vis- eries and technological advances, the problem with ible increase in the gap between production and con- this hypothesis is that it ignores the effect of expected sumption beginning in the summer of 2014 in part may cost and price paths on the intertemporal choices explain the decline in prices from about $109 to about among alternative oil-production decisions. If future $40 per barrel. Whatever the source of the declines in production really were to decline inexorably, expected prices in the summers of 2014 and 2015, they yielded future prices ought to rise, other things held constant, consumption increases visible in the data beginning yielding incentives to conserve oil (and other deplet- around the same time periods, of approximately 1–2 able resources) for future periods. Accordingly, there mmbd each time. is a fundamental analytic flaw in the widely asserted While we should be very careful with respect to admonition that (additional) resource “conservation” drawing conclusions from aggregate production and is necessary to maintain “sustainability.”21 If we define consumption data—they may obscure underlying shifts “conservation” as a shift of some resource consumption in fundamental supply and demand conditions—these from the current time period—such as this year or this data show no obvious shift in those market conditions decade or some longer period—into some future one, that would explain so large a decline in prices. The no resource will be “depleted” during the current time consumption increase over the entire time period was period, in substantial part because of the effect of price about 3 mmbd, or about 3.3 percent. Prices declined expectations on incentives to allocate resource use by over 60 percent, suggesting a (short-run) demand over time, as just described. Therefore, oil (and other elasticity of about 0.6 (in absolute value), a number resource) markets are “conserving” in the sense that substantially higher than the 0.25 or so reported in the no depletable resource is being depleted in the cur- literature.25 Since global GDP growth was about 2.6 rent time period; the “conservation for sustainability” percent in 2014 and 2.4 percent in 2015,26 a relative argument boils down to an assertion that market forces yield too little “conservation” in some undefined sense, the basis for which remains entirely unclear.22 23 It is hardly the case that the (approximate) marginal production costs for Saudi competitors are unknown. See Koema, Returning to the dynamic profit-maximization “Cost of Oil Production by Country”; and Rystad Energy, (“punishment of competitors”) argument: One would “Overview.” 24 For the price data, see Investing.com, “Brent Oil Histori- 20 For the original exposition of the peak oil hypothesis, cal Data.” For the production and consumption data, see the see M. King Hubbert, “Nuclear Energy and the Fossil Fuels,” US Energy Information Administration, “Short-Term Energy presentation at the American Petroleum Institute, March Outlook,” Table 3a, https://www.eia.gov/forecasts/steo/data. 1956, in Energy Bulletin, March 8, 2006, http://www2. cfm?type=tables. The production data include lease conden- energybulletin.net/node/13630. See also, e.g., Peak Oil, sate, natural gas liquids, and other liquids; the consump- http://www.oildecline.com/. tion data are defined roughly as total petroleum products 21 See, e.g., National Geographic Society, “Conservation,” supplied, which includes products produced from non-crude http://education.nationalgeographic.org/encyclopedia/ liquids, refinery processing gains, and the like. conservation/; and Sustainable Communities, “Protecting 25 See Hamilton, “Understanding Crude Oil Prices.” Natural Resources,” http://www.sustainable.org/environment. 26 See The World Bank, Global Economic Perspectives, 22 I have yet to find in the literature or elsewhere a defini- January 2016, http://www.worldbank.org/en/publication/ tion of “sustainability” that is analytically useful. global-economic-prospects/data.

AMERICAN ENTERPRISE INSTITUTE 5 Figure 2. Crude Oil Prices, Consumption, Production

120 98 97 100 96 95 80 94 93 60 92 91 40

US Dollars per Barrel 90 Millions of Barrels per Day 20 89 88 0 87

y 14 v 14 y 15 v 15 n 16 eb 14 Jul 14ug 14 an 15 Apr 15 un 15Ju l 15 Oct 15 Jan 14F Mar 14Apr Ma14 Jun 14 A Sep 14Oct 14No Dec 14J Feb 15Mar 15 Ma J Aug Sep15 15 No Dec 15Ja Feb 16Mar 16

Month/Year

Price Consumption Production

Sources: Investing.com, “Brent Oil Historical Data,” http://www.investing.com/commodities/brent-oil-historical-data; and US Energy Information Administration, “Short-Term Energy Outlook,” May 10, 2016, https://www.eia.gov/forecasts/steo/data.cfm?type=tables.

downward shift in demand conditions is unlikely to that low current prices will yield higher future ones, explain this price decline, particularly given that global as an expected increase in future prices ought to be consumption of crude oil increased from 92.4 mmbd in reflected in current prices. But the increase in commer- 2014 to 93.7 mmbd in 2015.27 cial inventories held in the OECD economies—from about 2.6 billion barrels in January 2014 to about 3.1 One is led to conclude that something about market billion barrels in March 2016, or about 19 percent—is expectations changed, a parameter much more difficult consistent with that argument, in that an expectation to measure. Whatever the reality, the price data are not of an increase in prices faster than the market rate of consistent with an expectation of future prices sharply interest should engender efforts to profit from that higher because of a Saudi strategy of dynamic profit anticipated price change by stockpiling more oil for maximization or punishment of competitors. Figure 3 sale when prices are expected to have increased. This presents the monthly price data shown in Figure 2, for is illustrated more clearly in Figure 4, which shows the 2014–2016, and data also on commercial inventories monthly OECD inventories for January 1997 through of crude oil held in the Organisation for Economic March 2016. Inventories were more or less constant Co-operation and Development (OECD) economies.28 over the entire period until the spring of 2014, a bit Figure 4 presents the monthly inventory data for before prices collapsed during the ensuing summer 1997–2016.29 and fall. In Figure 3, the sharp decline in prices beginning in the Note that there is no obvious reason that efforts to summer of 2014 presents a problem for the argument arbitrage the difference between current and future prices should yield increases in inventories; some 27 See the US Energy Information Administration, “Short- Term Energy Outlook,” Table 3a. crude oil that otherwise would be produced during the current time period could be left in the ground, to be 28 Ibid. lifted when prices prove higher. There might be some 29 Ibid.

AMERICAN ENTERPRISE INSTITUTE 6 Figure 3. Crude Oil Prices and OECD Commercial Inventories

120 3,500

3,000 100

2,500 80 s

2,000 60 1,500

40 Millions of Barrel

US Dollars per Barrel 1,000

20 500

0 0

14 v 14 y 15 l 15 v 15 ay n 16 an 14eb 14 Jul 14ug 14 an 15 Apr 15 un 15Ju J F Mar 14 Apr 14M Jun 14 A Sep 14Oct 14No Dec 14J Feb 15Mar 15 Ma J Aug 15Sep 15Oct 15No Dec 15Ja Feb 16Mar 16

Month/Year Price OECD Crude Oil Inventories

Figure 4. OECD Crude Oil Commercial Inventories

3,500

3,000

2,500 s

2,000

1,500 Millions of Barrel 1,000

500

Jan-16 Jan-15 Jan-13 Jan-11 Jan-09 Jan-07 Jan-05 Jan-03 Jan-01 Jan-99 Jan-97 Sep-15 Sep-13 Sep-11 Sep-09 Sep-07 Sep-05 Sep-03 Sep-01 Sep-99 Sep-97 May-14 May-12 May-10 May-08 May-06 May-04 May-02 May-00 May-98

Month/Year

Source: US Energy Information Administration, “Short-Term Energy Outlook,” May 10, 2016, https://www.eia.gov/forecasts/steo/data.cfm?type=tables.

AMERICAN ENTERPRISE INSTITUTE 7 Table 1. Oil Price Increase $40 to $100: Implicit Annual Rates of Return

------—————------——————------Year of Sale at $100------—————-——————------Price 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2030

$40 150 58 36 26 20 17 14 12 11 7

Source: Author’s computations.

sort of plausible argument to the effect that holders prices would not reflect such high rates of return. Even of inventories are more efficient than oil producers at the 7 percent annual return earned from selling oil at such arbitrage activities, although they often are the $100 in 2030 is comparable to recent returns earned same people or firms, and this hypothesis seems a bit on high-yield (“junk”) debt.31 (I put aside here the issue forced. Or there might be engineering, contractual, of inflation expectations and the distinction between cost, or other considerations or constraints on pro- nominal and real rates of return.) And it is unlikely duction changes once wells are producing, parameters that the prediction of price increases caused by Saudi that might make in-reservoir storage more costly as an dynamic profit maximization extends out more than arbitrage tool. This question of identifying the efficient 15 years in the future; why would the investment, provider of inventory capacity is a side issue that I production, and price effects of current low prices take leave for another day. so long?32 In any event, we have a conundrum: Even given the Any other assumed future price can be substituted in price increases since January, the price data seem place of $100. For example, suppose that $60 is the inconsistent with the dynamic profit maximization assumed future price. Then for the years shown in Table argument, in particular if the attendant prediction is 1, the implicit annual rates of return would be 50, 22, for a return to prices approximating $100 per barrel. 14, 11, 8, 7, 6, 5, 4.6, and 3 percent, respectively. In par- But the inventory data are consistent with it. Perhaps ticular for a $60 price anticipated in the earlier years, the problem is that the dynamic profit maximization these rates of return seem sufficiently high to induce the argument for Saudi behavior predicts only a qualitative arbitrage behavior just described, and with it a reflec- future price increase, rather than an actual quantitative tion of future expected prices in current prices. forecast. In any event, there is no obvious path toward Nor are such high prospective returns reflected in reconciling this problem, but a simple conceptual futures prices, as illustrated in Figure 5, which displays experiment and the data on futures prices do, I believe, the April 25, 2016, data on futures prices for delivery allow us to favor the inferences from the price data of Brent crude oil for each month from June 2016 over those from the inventory data. through December 2023.33 At a conceptual level, suppose that because of the As of April 25, 2016, prices for Brent crude oil investment effect of dynamic profit maximization by increased (in nominal dollars) from $45.43 for the Saudis, low prices today will yield high prices over delivery in June 2016 to $57.54 for delivery in Decem- the foreseeable future. Suppose also that prices were to ber 2023. This is a compound annual increase of return to a level approximating those observed at the beginning of 2014, say, $100 per barrel. If prices now 31 See the recent data reported by Investco, “High Yield are $40 per barrel, it is useful to ask what annual rate Bonds in a Rising Rate Environment,” March 2016, https:// of return would be earned by those conserving a barrel www.invesco.com/pdf/HYBRR-FLY-1.pdf. of oil in 2016 in favor of selling it at alternative times in 32 The discovery and development of new oil fields can take the future. Table 1 presents those calculations.30 a number of years, particularly for offshore resources, but the other dimensions of industry expansion (at both intensive However risky the nature of implicit investment in and extensive margins) often are accomplished more quickly. future oil sales, it simply is not plausible that current See IFP School, “What Are the Main Steps of an Oil or Gas Field Development Project?” http://www.ifp-school.com/ 30 The calculations are straightforward: The annual com- upload/docs/application/pdf/2015-02/3_main_steps_oil_ [1/(y − y )] gas_field_development.pdf. pound rate of return is [(pt/p0) t 0 ] where pt is the assumed price in future year t ($100 in our example), p0 is 33 See the futures price data reported in Barchart.com, the current price ($40), yt is the year of sale (e.g., 2020), and “Crude Oil Brent (F) Futures Prices,” http://www.barchart.com/ y0 is the current year (2016). commodityfutures/Crude_Oil_Brent_(F)_Futures/QA.

AMERICAN ENTERPRISE INSTITUTE 8 Figure 5. Brent Oil Futures Prices

US Dollars per Barrel 20

0 Jul-16 Jul-17 Jul-18 Jul-19 Jul-20 Jul-21 Jul-22 Jul-23 Mar-17 Mar-18 Mar-19 Mar-20 Mar-21 Mar-22 Mar-23 Nov-16 Nov-17 Nov-18 Nov-19 Nov-20 Nov-21 Nov-22 Nov-23

Month/Year

Source: Barchart.com, “Crude Oil Brent (F) Futures Prices,” April 25, 2016, http://www.barchart.com/commodityfutures/Crude_Oil_Brent_(F)_ Futures/QA.

3.2 percent, somewhat higher than current 10-year technological advances in oil consumption might shift inflation expectations of 1.71 percent.34 This dispar- the function up or down, as efficiency improvements ity seems reasonable given the volatility of oil prices, could be offset partially, fully, or more than fully by the greater riskiness of investment in a given (com- new ways to use oil. However speculative such param- modity) sector, and the possibility of future disrup- eters, a future large price increase driven by current tions in oil supplies, a topic to which I turn below. Saudi pricing policy either is absent from the futures The possibility of oil supply disruptions ought to data or is being hidden by other factors more impor shift the entire expected price path upward, rather tant. Neither the current nor the futures price data than increase its slope, unless there are reasons to appear to support the dynamic profit maximization believe—development of an Iranian nuclear weapon as argument, although the inventory data are consistent an example—that the likelihood of such a disruption with it. will increase over time. The prospect of future technological advances in oil production could be predicted to reduce the slope of this futures function or to shift III. Observations on Threats to the entire function downward to the extent that such the House of Saud technological advances can be foreseen.35 Future That the Middle East is a dangerous neighborhood is 34 For 10-year inflation expectations, see Federal Reserve no secret, a reality that for decades has confronted the Bank of Cleveland, “Inflation Expectations,” April 14, 2016, House of Saud with threats both internal and external. https://www.clevelandfed.org/our-research/indicators- A few examples should suffice to illustrate the point. and-data/inflation-expectations.aspx. Obviously, expectations The Grand Mosque in Mecca was seized in late 1979, for oil prices and for inflation are not independent. and that violent rebellion was put down only after 35 Again, a foreseen change in future oil prices ought to be almost two weeks and with the unofficial aid of French reflected in current prices.

AMERICAN ENTERPRISE INSTITUTE 9 troops.36 The bombings in Riyadh in May and Novem- price.42 This led to a steady decline in Saudi output ber of 2003 exposed the violent rifts between the from 9.9 mmbd in 1980 to 3.4 mmbd in 1985.43 Saudi monarchy and the Wahhabi religious establishment.37 production increased more or less monotonically (In this context, bombings directed against Americans beginning in 1986, a year in which the market price for clearly were a continuation of domestic politics by Brent crude oil fell by almost half, from $27.56 in 1985 other means.) More generally, bombings and shooting to $14.43 (in nominal dollars).44 incidents aimed at the regime have occurred on a regu- One interpretation of this shift during the mid- to lar basis, too numerous to detail in this essay.38 late-1980s is consistent with a straightforward effort The central long-term external threat has come from by the Saudis to protect their market share and sales Iran in the wake of the overthrow of the Shah of revenues.45 Another interpretation is consistent with Iran and the establishment of the Iranian theocratic Hassett’s argument: a production/pricing model that regime.39 One result has been a series of proxy battles can be described as “market punishment” behavior in Lebanon, Iraq, Afghanistan, Syria, Bahrain, and designed to reduce the profitability of foreign invest- Yemen.40 The more recent development of the Iranian ment in competing crude oil reserves. That model nuclear weapons program poses a direct and enormous suggests an increase in Saudi reserves and production perceived threat to the House of Saud.41 capacity, so as to create a threat to flood the market in the face of increasing potential competition. That Of greater interest here are the implications of these indeed is what we find: an increase in proven Saudi threats for Saudi oil production policy, and in particu- crude oil reserves from 173 billion barrels in 1989 lar the shift in that policy several years after the over- to 258 billion barrels in 1990.46 (Investment in the throw of the Shah. For 1973–1986, Saudi production discovery and development of new production capacity was consistent with the goal of protecting the official would be expected to show up in the data suddenly, as OPEC price; the Saudis acted as the “swing producer” new fields are “proven” in an engineering sense.) increasing or cutting output so as to maintain that However, Saudi reserves have remained virtually unchanged since 1990, increasing from 258 billion bar- 36 See Yaroslav Trofimov,The Siege of Mecca: The 1979 rels that year to only 268 billion barrels in 2015, even Uprising at Islam’s Holiest Shrine (New York: Anchor Books, as Saudi production increased from 5.6 mmbd in 1989 2008); and Lawrence Wright, The Looming Tower: Al-Qaeda to 11.6 mmbd in 2014.47 Figure 6 shows these data for and the Road to 9/11 (New York: Vintage Books, 2007). 37 See BBC News, “Saudi Bombing Deaths Rise,” May 13, 2003, http://news.bbc.co.uk/2/hi/middle_east/3022473. 42 See Benjamin Zycher, “OPEC,” in The Concise Encyclo- stm, and CNN, “Saudi Official Blames Riyadh Attacks on al pedia of Economics, ed. David R. Henderson (Indianapolis: Qaeda,” November 9, 2003, http://www.cnn.com/2003/ Liberty Fund, 2008), http://www.econlib.org/library/Enc/ US/11/08/saudi.explosion/. OPEC.html; and the Saudi historical production data for crude oil, https://www.eia.gov/forecasts/steo/tables/ 38 See Matthew Levitt, “Iranian and Hezbollah Threats to ?tableNumber=7#startcode=1997. For the older data, see Saudi Arabia: Past Precedents,” Washington Institute for Near IndexMundi, “Saudi Arabia Crude Oil Production by Year,” East Policy, PolicyWatch 2426, May 19, 2015, http://www. http://www.indexmundi.com/energy.aspx?country= washingtoninstitute.org/policy-analysis/view/iranian-and- sa&product=oil&graph=production. hezbollah-threats-to-saudi-arabia-past-precedents; and Trofi- mov, The Siege of Mecca; and Wright, The Looming Tower. 43 Ibid., IndexMuni. 39 See Wilson Center, “Timeline of Iran-Saudi Relations,” 44 See BP Global, BP Statistical Review of World Energy, January 5, 2016, https://www.wilsoncenter.org/article/ June 2015, http://www.bp.com/content/dam/bp/pdf/ timeline-iran-saudi-relations. energy-economics/statistical-review-2015/bp-statistical- review-of-world-energy-2015-full-report.pdf. 40 See Michael Knights, “What Would a Saudi-Iran War Look Like? Don’t Look Now, But It Is Already Here,” 45 See Zycher, “OPEC.” As noted above, any individual pro- Washington Institute for Near East Policy, January 11, 2016, ducer faces elastic demand—price and sales revenues move in http://www.washingtoninstitute.org/policy-analysis/view/ opposite directions, other things equal—so that a cut in price what-would-a-saudi-iran-war-look-like-dont-look-now-but- and increased production would increase (or protect) sales it-is-already-here; and Henry Johnson, “This Map Explains revenues. the Saudi-Iran Proxy War,” Foreign Policy, January 6, 2016, 46 See the historical data reported by the US Energy Infor- http://foreignpolicy.com/2016/01/06/this-map-explains- mation Administration, “Crude Oil Proved Reserves (Billion the-saudi-iran-proxy-war/. Barrels),” http://www.eia.gov/cfapps/ipdbproject/iedindex3. 41 See Anthony H. Cordesman, “Saudi Arabia, Iran, and cfm?tid=5&pid=57&aid=6&cid=regions&syid=1995&eyid= the ‘Clash Within a Civilization,’” Center for Strategic and 2015&unit=BB. International Studies, February 3, 2014, http://csis.org/ 47 See the historical production data reported by the US publication/saudi-arabia-iran-and-clash-within-civilization. Energy Information Administration, “International Energy

AMERICAN ENTERPRISE INSTITUTE 10 Figure 6. Saudi Reserves and Production

300 14

12 250

10 200

8 150 6

Billions of Barrel s 100 4 Millions of Barrels per Day 50 2

0 0

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Month/Year Reserves (left) Production (right)

Sources: US Energy Information Administration, “International Energy Statistics,” http://www.eia.gov/cfapps/ipdbproject/IEDIndex3.cfm?tid=5&pid= 57&aid=6; US Energy Information Administration, “International Energy Statistics,” http://www.eia.gov/cfapps/ipdbproject/iedindex3.cfm?tid=5&pid= 57&aid=6&cid=regions&syid=1995&eyid=2015&unit=BB; and US Energy Information Administration, “International Energy Statistics,” http://www. eia.gov/cfapps/ipdbproject/iedindex3.cfm?tid=5&pid=55&aid=1&cid=ww,SA,&syid=1980&eyid=2015&unit=TBPD.

1980 through 2015. The Saudi market share of world extreme case in which the royal family’s private jets are crude oil production for 1991–2014 remained fairly kept fully fueled and ready for quick departure to Swit- stable at 12–14 percent, as world production increased zerland, the suppression of investment incentives for from 65.3 mmbd to 90.7 mmbd, or by 39 percent.48 international competitors becomes far less important. The dynamic profit maximization argument seems not Accordingly, it may be useful to conduct a rough con- to answer the obvious question: Why have the Saudis ceptual exercise to see what change in Saudi produc- failed to increase capacity so as to profit from this tion levels might result from increased fears of some growing market? Or: Why have they failed (at least sort of overthrow or coup d’état, that is, an increase until mid-2014) to punish the market so as to discour- in the discount rate used (implicitly) by the House age investment by competitors? of Saud to evaluate the value of future oil revenues. One answer might be consistent with the growing I assume here that the Saudi maximand is the pres- threats perceived by the House of Saud. If the risk ent value of total sales revenue, and a price elasticity of an overthrow by hostile forces has increased, the of demand for Saudi oil of three (in absolute value). Saudi ruling family might have greater incentives to Obviously, other figures could be substituted, but the maximize sales revenue over a shorter time horizon. qualitative nature of the analysis would not change. That can be interpreted as “dynamic profit maximiza- Table 2 summarizes these calculations for two cases: tion” with a much higher discount rate. After all, in the time horizons for the House of Saud of 100 years and 10 years, with an assumption that optimal production under the 100-year time horizon is 12 mmbd (about Statistics,” at http://www.eia.gov/cfapps/ipdbproject/iedindex3. cfm?tid=5&pid=55&aid=1&cid=ww,SA,&syid=1980&eyid=2015 4.4 billion barrels per year) at $40, with a discount &unit=TBPD. These data include production of natural gas rate of 5 percent applied to the revenue stream. These liquids, lease condensates, and other liquids. assumptions yield annual revenues of $175 billion, with 48 Ibid. a present value a bit less than $3.5 trillion.

AMERICAN ENTERPRISE INSTITUTE 11 Table 2. House of Saud Oil Production Under 100-Year and 10-Year Horizons

100-Year Horizon 10-Year Horizon (5% discount rate) (10% discount rate)

Annual oil production (billion barrels) 4.4 7.7

Price per barrel ($) 40 30

Annual total revenues ($ billions) 175 233

Revenues present value ($ billions) 3,473 1,843

Source: Author’s computations, available upon request.

For the 10-year period, I assume a discount rate of 10 House of Saud no longer is dumping oil on the market. percent, reflecting an increase in the perceived threats Investment incentives for foreign competitors might be to the House of Saud and thus a shortening of its time preserved. The punishment hypothesis also might yield horizon. That increased fear in this conceptual exercise higher future prices, but it still maintains the threat to changes the Saudi maximand to the present value of drive prices down after foreign competitors have sunk sales revenues over that 10-year horizon. Under the large investments into new production facilities.50 assumption discussed above that sales revenue is a Note also that a (perhaps explicitly Wahhabi) regime reasonable proxy for profits, this change in conditions replacing the House of Saud also would face threats induces a price cut from $40 to $30 per barrel, a pro- to its political control of the Arabian government and duction increase to about 21 mmbd (about 7.7 billion oil revenues, and presumably would need revenues to barrels per year), and annual revenues of about $300 placate its enemies both internal and external. Other billion, with a present value of $1.8 trillion.49 Accord- regimes in the region would have the same incentives ingly, this simple “threat” exercise reduces the present to disrupt Arabian production so as to raise market value of the revenue stream by about half. prices. At the same time, it is reasonable to hypothesize This conceptual exercise is far from obviously “cor- that an Arabian regime driven explicitly by Wahhabi rect” in the sense that several alternative quantitative ideology might have stronger political preferences to assumptions would be equally plausible and might “punish” the West by reducing output and perhaps yield different numbers. But neither is it obviously investment, yielding higher prices over the short run. flawed. The interesting observation to be made is But in contrast with a Saudi dynamic profit maximiza- that the current production/price implications of an tion/punish competitors strategy, this Arabian/Wah- overthrow/coup d’état threat assumption appear not habi strategy implies a reduction in the importance of very different from those attendant upon a dynamic Arabian oil production over time and increased incen- profit-maximization assumption in which the goal tives for investment in production capacity by overseas is punishment of overseas competitors. But those competitors. alternative hypotheses imply different implications The recent decline in prices is consistent with a for future investment by those competitors: The number of hypotheses, and several may play a part in coup d’état hypothesis at least arguably yields higher observed changes in Saudi behavior and resulting mar- long-run prices in the future periods during which the ket conditions. A straightforward example is the Saudi desire to reduce revenues earned by the Iranians, a 49 Under a demand elasticity assumption of 3, a $35 price regime that can be described without exaggeration as a increases annual Saudi sales to about 6 billion barrels and Saudi enemy and military threat.51 But that hypothesis annual sales revenues to $211 billion, with a present value of about $1.3 trillion. For a $25 price, the respective figures are 9.3 billion barrels, $233 billion, and $1.4 trillion. For a $20 50 The Wahhabi or other “Arabian” regime replacing the price, the respective figures are 11 billion barrels, $219 billion, House of Saud is likely to face similar incentives: threats to its and $1.3 trillion. If we assume no change in the discount rate control of oil revenues and a time horizon shorter rather than from 5 percent, the 10-year horizon yields the same maximiz- longer. This might not be the case if the new regime were to ing price of $30, production of 7.7 billion barrels per year, enjoy protection from the Iranians and their (future) nuclear and annual sales revenues of $300 billion with a present umbrella. value of $2.3 trillion. 51 See Wilson Center, “Timeline of Iran-Saudi Relations.”

AMERICAN ENTERPRISE INSTITUTE 12 Figure 7. Oil Supply Disruptions

3.5

3.0

2.5

2.0

1.5

1.0

Millions of Barrels per Day 0.5

0 Jul-15 Jul-13 Jul-14 Jul-12 Jul-10 Jul-11 Jan-16 Jan-14 Jan-15 Jan-13 Jan-11 Jan-12 Jan-10 Mar-15 Mar-13 Mar-14 Mar-12 Mar-10 Mar-11 Nov-15 Nov-13 Nov-14 Sep-15 Nov-12 Sep-13 Sep-14 Nov-10 Nov-11 Sep-12 Sep-10 Sep-11 May-15 May-13 May-14 May-12 May-10 May-11

Month/Year OPEC Non-OPEC Total

Sources: US Energy information, “International Energy Statistics,” Administration, http://www.eia.gov/cfapps/ipdbproject/iedindex3.cfm?tid= 5&pid=53&aid=1&cid=ww,&syid=2010&eyid=2015&unit=TBPD; and US Energy information Administration, “What Drives Crude Oil Prices?” https://www.eia.gov/finance/markets/supply-opec.cfm.

cannot explain the increase in prices observed since disruptions may be a more or less permanent feature of January. One conjecture might be that the increas- the market. Since 2000, Saudi production of crude oil ing size of world output disruptions has driven the (not including associated liquids) has increased from increase, as illustrated in Figure 7.52 roughly 8.4 mmbd to about 10.0 mmbd in 2015.53 This might be consistent with heightened Saudi fears of Non-OPEC disruptions have been declining, while political threats increasing the attractiveness of current OPEC disruptions are both larger and growing. For revenues relative to future ones. Revenues earned the world as a whole, the average monthly disruption sooner also might be viewed as more valuable in terms in 2012 was 1.9 mmbd. For 2013–2015, the respective of buying political support. figures are 2.7 mmbd, 2.9 mmbd, and 3.1 mmbd. (If we include the smaller numbers for January through March 2016 in the 2015 average, it still is 2.9 mmbd.) IV. Price Effects of a “Severe” Figure 8 shows the trend for world supply disruptions as a percent of world production; that percentage has Supply Disruption been growing as a longer-term trend since 2011. To the extent that the higher prices observed since Jan- Accordingly, the recent price increases seem to be con- uary 2016 have resulted from increased market expec- sistent with a possible perception that growing supply tations of supply disruptions, it is interesting to think about the likely price effects of a “severe” disruption, 52 For an illustration of recent supply disruptions, see the most obvious scenario for which would be a cutoff US Energy Information Administration, “Supply: OPEC,” https://www.eia.gov/finance/markets/supply-opec.cfm. For a long-run view, see BP, “Oil Prices,” http://www.bp.com/ 53 For 2000–2014, see US Energy Information Adminis- en/global/corporate/energy-economics/statistical-re- tration, “Crude Oil Proved Reserves.” For 2015, see YCharts, view-of-world-energy/oil-review-by-energy-type/oil-prices. “Saudi Arabia Crude Oil Production,” https://ycharts.com/ html. indicators/saudi_arabia_crude_oil_production.

AMERICAN ENTERPRISE INSTITUTE 13 Figure 8: Supply Disruptions as Percent of World Production

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Nov-15 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 May-10 May-11 May-12 May-13 May-14 May-15

Month/Year

Sources: US Energy information Administration, “What Drives Crude Oil Prices?” https://www.eia.gov/finance/markets/supply-opec.cfm; and US Energy Information Administration, “Short-Term Energy Outlook,” Table 3a, https://www.eia.gov/forecasts/steo/tables/?tableNumber=6#endcode= 201712&periodtype=m&startcode=201201.

of Persian Gulf crude supplies due to a war interrupt- that is, a quadrupling. Let us assume also that producing shipments through the Strait of Hormuz. ers outside the Persian Gulf increase output by, say, 1 million barrels per day each year beginning in the sec- Persian Gulf production in 2015 was about 24.4 mmbd, ond year. This response in part is caused by the price or 30 percent of world production of about 80.1 mmbd.54 increase and in part moderates the price increase.56 If Let us assume a worst-case scenario in which these we assume that half of that total production increase supplies are removed from the world market for, say, moderates prices, the true “supply” effect is 500,000 10 years. I assume also that Persian Gulf production barrels per day each year beginning in the second year. would not have increased in the absence of the disrup- Table 3 summarizes these production and price effects tion, and that the world price elasticity of demand for for the 10 years beginning with the disruption assumed crude oil is 0.10 (in absolute value) in the short run, to occur in 2017. increasing by 0.025 each year for the duration of the disruption.55 The immediate effect upon the world This simulation is highly simplistic and artificial. In market price of oil, caused by a supply reduction of particular, Persian Gulf production is assumed to have 30 percent, would be an increase of about 300 percent, been constant (not growing) over the disruption period had there been no disruption, and the same is true for 54 See US Energy Information Administration, Monthly market demand conditions (only the disruption and Energy Review, March 2016, p. 167, Table 11.1b, http://www. resulting price effects change consumption behavior). eia.gov/totalenergy/data/monthly/pdf/sec11_5.pdf. These data are for crude oil and lease condensate; they exclude natural gas liquids. 56 In other words, part of the supply response is an upward 55 This assumption is driven by the standard axiom that the movement along the existing non–Persian Gulf supply func- elasticities of demand and supply increase with time, that is, tion due to higher prices, and part is an outward shift of the ever-greater adjustments to a shift in exogenous conditions non–Persian Gulf supply curve resulting from the increased become economic as more time is allowed to make them. investment (rate of return) driven by the price increase.

AMERICAN ENTERPRISE INSTITUTE 14 Table 3. Simulated Crude Oil Production and Price Effects

------——------mmbd------——------Disruption Non-Persian Gulf Net Output Price Increase Price Year Supply Response Cut (Percent) (Year 2016 $) 2016 0 0 0 0 40 2017 24.4 0 24.4 305 162 2018 24.4 0.5 23.9 239 135 2019 24.4 1.0 23.4 195 118 2020 24.4 1.5 22.9 163 105 2021 24.4 2.0 22.4 140 96 2022 24.4 2.5 21.9 122 89 2023 24.4 3.0 21.4 107 83 2024 24.4 3.5 20.9 95 78 2025 24.4 4.0 20.4 85 74 2026 24.4 4.5 19.9 76 71 2027 24.4 5.0 19.4 69 68

Source: Author’s computations, which assume predisruption world production of 80 mmbd of crude oil.

To the extent that Persian Gulf output is the marginal What is interesting is how short the periods of high or source of world supplies, those assumptions offset each rising prices are. This may be due to market adjust- other qualitatively, but it is not the case that increased ment processes, the effect of high prices on new invest- world output comes only from the Persian Gulf.57 ment, or perhaps other factors. This historical pattern is consistent with the results of the simple simulation But this exercise, whatever its shortcomings, is reveal- reported in Table 3. ing. World crude oil prices only two years ago were at about $109 per barrel, only about one-third lower than the price ($162) to which the market in the first year V. An Aside: Two Criticisms of would be driven by this severe hypothetical disruption under a reasonable approximation of current market Conventional Wisdom conditions. The assumption of a demand elasticity of The analytic errors inherent in two common dimen- 0.1 biases the derived price increase upward; the actual sions of conventional wisdom can be summarized as elasticity is likely to be higher.58 Market forces yield follows. steady declines in prices over time, after only a few years to levels not vastly higher than those observed First, many observers and commentators on the recently in the absence of severe disruptions, but with international oil market often refer to pricing and pro- some considerable ongoing turmoil in the Middle East. duction behavior by “the OPEC cartel,” but that char- acterization is problematic.60 OPEC has never behaved Figure 9 illustrates this pattern of relatively quick recov- like a cartel, at least in the classic sense of allocating ery from the effects of supply disruptions by displaying production shares so as to equate marginal produc- the historical data on oil prices for 1861–2014.59 tion cost across producers. It is Saudi production that historically has determined world market prices simply because Saudi production and reserves have been so 57 See US Energy Information Administration, “Crude Oil large. It is more useful analytically to view OPEC as one Proved Reserves.” big producer determining the market price as driven 58 See Hamilton, “Understanding Crude Oil Prices.” by some complex mix of policy goals, and a number of 59 For the historical data, see BP, Statistical Review of World Energy: Data Workbook, June 2015, http://www. bp.com/en/global/corporate/energy-economics/statistical- 60 See Daniel Yergin, The Prize: The Epic Quest for Oil, review-of-world-energy.html. Money, and Power (New York: Free Press, 1992), esp. 718–24.

AMERICAN ENTERPRISE INSTITUTE 15 Figure 9. Historical Oil Prices

140

120

100

40 2014 US Dollars per Barrel

0 1861 1867 1873 1879 1885 1891 1897 1903 1909 1915 1921 1927 1933 1939 1945 1951 1957 1963 1969 1975 1981 1987 1993 1999 2005 2011 2014

Year

Source: BP, Statistical Review of World Energy: Data Workbook, June 2015, http://www.bp.com/en/global/corporate/energy-economics/statistical- review-of-world-energy.html.

smaller ones who accept that price and then try to find prices, and it was the US system of price and allocation ways to erode it so as to garner bigger market shares controls that created the queues and other market dis- (revenues) for themselves. An example of such price tortions. There was no embargo in 1979, but there was shaving is credit for buyers extending beyond the usual a production cutback in the wake of the Iranian revo- 30 days. Games can be played also with the qualities of lution, and the US again imposed price and allocation oil delivered and with a number of other parameters.61 regulations. Once again, there were queues and market distortions.62 Second, many observers argue that it was the 1973 OPEC oil embargo that created the gasoline queues and other market distortions observed in the United VI. Conclusions States, but that historical interpretation is not correct. Since there was and remains one world market for The basic problem with the dynamic profit maximi- crude oil, an embargo—a refusal to sell to a given buyer zation/market punishment model of Saudi strategy is (i.e., impose a higher price on that buyer only)—cannot straightforward: It seems to imply a sine wave of price work because market forces will reallocate oil until increases and declines over time. Should those not be prices are equalized everywhere, adjusting for such foreseeable? That model falls short as economic anal- minor complications as differential transport costs. The ysis because it asks the wrong question: Will future oil 1973 embargo aimed at the US, the Netherlands, and prices remain low? The correct question is much more a few others had no effect at all: The targeted nations difficult: Why are current prices not far higher already? obtained oil on the same terms as all other buyers, After all, dynamic profit maximization by the Sau- although the transport directions of oil trade changed dis, aimed at reducing competitive investments in because of the reallocation process. It was the production cutback by Arab OPEC that raised international 62 See Benjamin Zycher, “Emergency Management,” in Free Market Energy: The Way to Benefit Consumers, ed. S. Fred 61 See Zycher, “OPEC.” Singer (New York: Universe Books, 1984), 74–98.

AMERICAN ENTERPRISE INSTITUTE 16 production capacity, is hardly a secret, and it simply Hassett has done a real service by writing an intelligent is not plausible that current prices do not reflect this essay forcing all of us to confront the conundrum of factor. Accordingly, the resulting inference—having international oil prices generally, and the complex and fallen sharply, prices will rise at a rate faster than the fascinating optimization problem faced by the House market rate of interest—can be restated a bit more of Saud in particular. This truly is an area in which spe- provocatively: The market is making a mistake obvi- cialists in economics and in the international politics ous, fundamental, and systematic. Perhaps it is, but and defense dynamics of the Middle East have much to that is not the smart way to bet when armed only with learn from each other. ex ante information available to all. If the proponents of that view have inside information—would they share it?—or hindsight derived from some sort of time About the Author travel, they are going to find themselves very wealthy Benjamin Zycher is the John G. Searle Scholar at the indeed. American Enterprise Institute. Moreover, that common view seems to ignore the cer- tainty that technological advances will continue, even if Acknowledgments we cannot describe them ex ante. Will such expectations have the effect of reducing both the level and the slope I thank William R. Allen, Kevin A. Hassett, Frederick of the future price path? It seems reasonable to hypoth- W. Kagan, Desmond Lachman, Mario A. Loyola, Derek esize that they will, and a discussion of price paths for Scissors, Charles Wolf Jr., and Weifeng Zhong for use- oil should take this factor into account. ful suggestions, but any remaining errors or omissions are my responsibility.

The American Enterprise Institute for Public Policy Research (AEI) is a nonpartisan, nonprofit, 501(c)(3) educational organization and does not take institutional positions on any issues. The views expressed here are those of the author(s).

AMERICAN ENTERPRISE INSTITUTE 17