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 disrup- tions 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.washingtoninsti- tute.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.