Fighting Fire with Fire - How Saudi Arabia's Oil Policy Backfired

A recent Wall Street Journal article opens a window into a new and unsettling world. More chaos in the oil markets and more instability in the Middle East.

Saudi Arabia sought to raise crude oil prices by driving US Shale producers and other low cost producers out of business. That is, by setting the oil market on fire with a flood of oil, they would set a price so low, US producers would have to shut in and stop drilling. They reasoned it would do two things.

1. Reduce supply and drive up the price; and,
2. Allow them to recapture market share.

But the strategy blew up in their faces for several reasons.

1. They underestimated the ability of US producers to drive costs lower. Never bet against innovation.
2. They underestimate their own cost of production. The Royal family has for decades kept the population content and docile with huge subsidies and lucrative government jobs. While their wellhead production costs are among the world’s lowest (~$10/barrel), the social costs have ballooned. One estimate by the Globe and Mail  holds that Saudi Arabia requires $100/barrel to balance its budget.
3. Rather than pressure US producers, it pressured the other members of OPEC sowing dissention and discord. The less wealthy members of OPEC have social costs too. With larger populations, lower productive capacity, higher well head costs and more restive Islamic militants, the other members of OPEC have little flexibility.
4. The US deal with Iran to relieve sanctions brought another 3-4 million barrels to market.
5. Iraq, pressured by its war with ISIS also needs more revenue and can ill afford to reduce production and indeed is pressing forward with increasing output according to Iraq Business News.

Now they are caught in a trap of their own making. The only option is to reduce their own output and suffer the revenue hit. Will that be enough to make a difference? Probably not. Both of its Gulf neighbors, Iran and Iraq            have spare capacity and are only too willing to grab market share. US shale producers are also hungry to sell more oil and will add production as long as the marginal cost exceeds the current price. That is now somewhere between $40 and $60/barrel and falling as producers get more efficient and focus on their most economic assets.

A real possibility is for more, not less, oil to come to market. If all the other producers have more productive capacity than the Saudi’s withdraw from the market, trust that it will be used. All indications are that this is the case. This implies that the price ceiling will come down, adding pressure to all producers to reduce costs. OPEC members really have but one option, reduce social costs. The consequence of that is likely to be more, not less instability in already shaky nations.