Is Saudi Arabia prepared to let oil price drop to $20?

Saudi Arabia seems to fighting two battles; one against oil shale and one against the Iran-Russia combination. In the long term both are doomed to failure. At best all that Saudi Arabia can hope for is that

  1. the smaller shale oil producers find it uneconomic to continue production, and
  2. Iran and Russia’s oil production is severely curtailed.

But any such result is bound to be temporary. It may force the reduction of investment in shale oil but Russia and Iran will need to produce more to keep their revenues up. It is unlikely to lead to the permanent impairment of oil production from shale or in Iran and Russia. It may allow Saudi Arabia to take control of pricing for a while but the OPEC monopoly has already gone. And the limited monopoly they can win, can only continue as long as oil price stays too low to make it economic for the shale and tar sands alternatives. The reestablished monopoly will only apply as long as oil stays cheap.

It becomes intriguing now as to whether Saudi Arabia has the nerve to allow prices to drop to as low as $20 per barrel and for how long? The long term benefits to Saudi Arabia are not quite so clear for me. Having a monopoly which does not allow prices to rise seems somewhat useless. Certainly their cost of extraction is so low (less than $5 per barrel) that they could continue making profits, but they would need to keep the price low for many years to see off the competition – and the competition would come back if prices rose again.

Anatole Kaletsky considers this question at his Reuters blog:

…… Low oil prices will last long enough for one of two events to happen. The first possibility, the one most traders and analysts seem to expect, is that Saudi Arabia will re-establish OPEC’s monopoly power once it achieves the true geopolitical or economic objectives that spurred it to trigger the slump. The second possibility, one I wrote about two weeks ago, is that the global oil market will move toward normal competitive conditions in which prices are set by the marginal production costs, rather than Saudi or OPEC monopoly power. This may seem like a far-fetched scenario, but it is more or less how the oil market worked for two decades from 1986 to 2004. ….

….. The key question is whether the present price of around $55 will prove closer to the floor or the ceiling of this new range. The history of inflation-adjusted oil prices, deflated by the U.S. Consumer Price Index, offers some intriguing hints. The 40 years since OPEC first flexed its muscles in 1974 can be divided into three distinct periods. From 1974 to 1985, West Texas Intermediate, the U.S. benchmark, fluctuated between $48 and $120 in today’s money. From 1986 to 2004, the price ranged from $21 to $48 (apart from two brief aberrations during the 1998 Russian crisis and the 1991 war in Iraq). And from 2005 until this year, oil has again traded in its 1974 to 1985 range of roughly $50 to $120, apart from two very brief spikes in the 2008-09 financial crisis.

What makes these three periods significant is that the trading range of the past 10 years was very similar to the 1974-85 first decade of OPEC domination, but the 19 years from 1986 to 2004 represented a totally different regime. It seems plausible that the difference between these two regimes can be explained by the breakdown of OPEC power in 1985 and the shift from monopolistic to competitive pricing for the next 20 years, followed by the restoration of monopoly pricing in 2005 as OPEC took advantage of surging Chinese demand. ….

……. There are several reasons to expect a new trading range as low as $20 to $50, as in the period from 1986 to 2004. Technological and environmental pressures are reducing long-term oil demand and threatening to turn much of the high-cost oil outside the Middle East into a “stranded asset” similar to the earth’s vast unwanted coal reserves. Additional pressures for low oil prices in the long term include the possible lifting of sanctions on Iran and Russia and the ending of civil wars in Iraq and Libya, which between them would release additional oil reserves bigger than Saudi Arabia’s on to the world markets.

The U.S. shale revolution is perhaps the strongest argument for a return to competitive pricing instead of the OPEC-dominated monopoly regimes of 1974-85 and 2005-14. Although shale oil is relatively costly, production can be turned on and off much more easily – and cheaply – than from conventional oilfields. This means that shale prospectors should now be the “swing producers” in global oil markets instead of the Saudis. In a truly competitive market, the Saudis and other low-cost producers would always be pumping at maximum output, while shale shuts off when demand is weak and ramps up when demand is strong. This competitive logic suggests that marginal costs of U.S. shale oil, generally estimated at $40 to $50, should in the future be a ceiling for global oil prices, not a floor. …

…… So which of these arguments will prove right: The bearish case for a $20 to $50 trading-range based on competitive market pricing? Or the bullish one for $50 to $120 based on resumed OPEC dominance?

Whether market pressures dominate or whether the cartel reestablishes control, we seem to be in for a long period of prices around $40 – 50 per barrel. At this price bio-diesel would need hefty subsidies to survive. Assuming that gas prices continue their link to oil prices, gas becomes the dominating choice as fuel for power generation. Renewable energy will need even greater subsidies which are already being cut back. Not all of this price reduction will be passed on to the transport industry. The pass through of the price cut will be greater in the US than in Europe or Asia. But any pass through is itself a stimulus for consumer spending.

For the stagnating world economy low oil prices can only be a good thing.

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