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Craig Feigin | Behind the oil price story
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20 Aug Behind the oil price story

Since June 2014 the international oil market is in an upheaval. Due to
different factors the demand of oil had dropped. Supply corrections were
widely expected by analysts given the historical rationale of the oil
suppliers to do so. Saudi-Arabia surprised all by not lowering their
production, causing the oil prices to drop drastically by over 40%. What
was their incentive to do so and is this a good strategy on long term?

* What was expected? *

Based on historical evidence Saudi Arabia, as a swing oil producer, used to
step in to correct the decline in oil prices by limiting their oil supply.
For instance in 2006 the oil prices, represented by the Brent index,
dropped markedly. Saudi Arabia intervened as expected by reducing their oil
supply which resulted in restored prices.

* What actually happened? *

Oil demand went down due to weak economic activity of the EU, Japan and
China, increased energy efficiency and a growing shift to alternative fuels.

Due to Saudi Arabia’s low marginal cost which is still far lower than the
oil price they can tolerate the price reduction. Furthermore considerable
financial reserves of $900 billion will keep their economy afloat. The
falling oil prices have hit the high-cost producers especially since they
can’t recuperate their production cost.

The expected shift of the supply curve to restore the price level didn’t
happen. This is due to political and economic factors.

Political factors:

· Iran’s reach across the Middle East region worries Saudi Arabia.
The latter wants to lower the price of oil to hit the former’s economy,
which is heavily reliant on hydrocarbons.

· Saudi Arabia also wants to hurt Russia, which heavily relies on
export revenues from oil, given that Russia has been a long-term ally of

Economic factors:

· 20 years ago OPEC share of global oil market was 50%. Today it
has fallen down to 33%. Hence, OPEC wants to increase its market share.

· In the last year, the number of oil platforms in US grew by 20%,
and the production by 15%. This was achieved on high cost shale oil

· OPEC wants to show that they have the power to heavily influence
oil prices. “Credible threat”.

As analyzed, Saudi Arabia, the world’s largest oil exporter (with 13% of
global oil production) and OPEC’s most influential member, has clear
economic and political incentives to allow oil prices to plummet by not
curbing its oil production. With the big amount of financial reserves, they
have the power to maintain this situation for a long period. But, as of
now, they have already shown that they have the power to influence the
prices “credible threat”.

Looking this situation as a whole, Saudi Arabia is showing the world that
they can, and they will, reduce or increase the oil prices in case they
have any political or economic reasons to do so. In addition, they are
discouraging the exploration of new sources of oil, ensuring a better price
for the future years when the demand is restored and the supply takes a few
months to recover.

Several ideas below are food for thought: Will Saudi Arabia still play the
role of the swing oil producer or relinquish it to non-OPEC suppliers? Will
multibillion dollar domestic projects stop as a consequence of low oil
prices? What is the future of new high cost drilling technologies? Will
there still be financing for new drilling projects taking into account the
big risk of having price fluctuations in hands Saudi Arabia?

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