The case for a new Saudi oil policy in a reborn global energy market

As oil prices started cratering last month, a group of US lawmakers from the southern oil-producing states accused Saudi Arabia of working to destroy the US shale oil industry. They overlooked both the role Russia played in refusing to accept Saudi Arabia’s proposal to cut output to keep prices up and the unprecedented destruction of demand for oil—because of the coronavirus pandemic—that pushed prices over the edge.

Russia was subsequently pressured to come back to the table last week, and an OPEC+ agreement quickly followed that gave a positive psychological boost to oil markets and handed a political win to President Donald Trump. However, oil prices have quickly resumed their downwards trajectory, confirming the hard reality that market fundamentals are determining outcomes. Whether in the United States or abroad, oil producers are finding that they can no longer manage the market as they once did.

The negotiations that led to the agreement reminded observers of Saudi Arabia’s central role in global oil and financial markets and belied claims that this has been eroded as a result of the United States “energy self-sufficiency.” Nonetheless, it mistakenly perpetuated the optimistic perception that oil prices can and will be actually “managed” by the major producers going forward. This may no longer be the case.

It is now increasingly clear to many people in Saudi Arabia that the nation’s long-term interests no longer lie in playing the role of “swing producer”, which the Kingdom has been doing since the 1970s. This involved regulating the price by either hiking output to avoid a dramatic rise in prices or cutting it to avoid their collapse. In turn, this policy helped producers of shale, and other high-cost producers, from having to confront the full force of a truly open global oil market.

In the past, Saudi leaders derived satisfaction from the belief that the “world” appreciated the Kingdom for playing this crucial stabilizing role. Yet, in fact, the country was incurring a substantial cost by maintaining the spare capacity that this policy required while generating little in terms of tangible monetary and political return. Indeed, Saudi Arabia was taken for granted by everybody, consumers and producers alike. Among the latter, many producers in OPEC often resorted to cheating by exceeding their quota, and producers outside OPEC always pumped to maximum capacity. In effect, everyone took advantage of the Kingdom’s production policy, which often resulted in less revenue for the Kingdom when the price of oil dropped and in a loss of market share when it rose—a lose-lose situation.

Oil is the lifeblood of the Saudi economy (not just a small part of a multitrillion-dollar economy like shale is to the US) and will continue to be for the foreseeable future. The diversification of the economy away from oil is a long-term goal for the Kingdom of Saudi Arabia. It will create export industries that compete globally and will be of sufficient size to replace the revenue generated from oil. But this will take time. The Kingdom’s Vision 2030 is exactly that, a vision, and a signal to the Saudi people of how determined Saudi leaders are to accelerate the process of diversification. Yet, as any economist knows, the realization of this goal will require the efforts of at least a generation.

Until this is achieved, Saudi Arabia should have two key objectives. The first is to make sure its financial reserves last as long as possible. The second is to ensure that the nation extracts the maximum value from oil, its only “crop”, for as long as possible. Here Saudi Arabia has a key advantage, namely that it is the lowest-cost oil producer and its oil reserves, with a production rate of thirteen million barrels per day, have a life span of over fifty years. Thus, a logical strategy is for Saudi Arabia to maximize its production, taking advantage of its lowest-cost advantage, and to capture as large a share of the world’s energy market as possible. So it makes little sense for the Kingdom to continue its “swing producer” role and incur further losses, even if this means taking market share from high-cost producers like US shale, deep-sea Brazilian oil, Canadian oil sands, North Sea oil, and even high-cost Chinese oil. This is the free market after all.

With this market reality in mind, it may be time for the shale industry in the United States to be acquired by the major oil companies such as Exxon and Chevron (or even the US government) to be maintained as a long-term strategic reserve for the US. Given the speed with which shale can be brought to market, such reserves can always be accessed if prices increase sufficiently or in the unlikely event that the US finds itself cut off from overseas supplies of cheaper oil.

The economics of shale, as many analysts have shown, has not, despite the hype, made much financial sense since its inception in recent years. This is an industry that devours enormous amounts of capital yet does not generate an appropriate return for its investors, let alone a positive cash flow, and it has only been able to survive because Wall Street bought into the hype and continued to supply it with abundant capital. At this point, Wall Street will probably realize that this no longer makes sense and that this resource will require considerably higher oil prices for a sustained period of time or else a geopolitical shock before it is worth bringing back to market. In the meantime, it can remain as a valuable strategic reserve for the United States that can be easily accessed if and when required.

Despite the recent OPEC+ agreement, people will gradually realize that free market dynamics will ultimately determine the economics of oil production for everybody. If certain types of oil are unprofitable, there will be little any country can do to protect their producers beyond implementing short-term measures like charging tariffs or extending massive subsidies. Such policies will only delay their day of reckoning and expose taxpayers to unnecessary costs at a time when they can hardly afford them.

Read more:

‘The death of US shale:’ Oil prices turn negative as coronavirus plunges market

Gulf producers, Russia skip OPEC+ conference call: Sources

US oil price crash a warning signal for Middle East producers: Experts

Last Update: Wednesday, 20 May 2020 KSA 09:54 - GMT 06:54
Disclaimer: Views expressed by writers in this section are their own and do not reflect Al Arabiya English's point-of-view.