Oil prices not too low for Saudi Arabia

My last post explained why international oil prices have fallen dramatically during the last six months. This has harmed the profitability of many oil producers.

International oil traders and producing companies have called on the Organisation of Petroleum Exporting Countries (OPEC) to react to the fall in oil prices. Saudi Arabia is the biggest producing country within OPEC and often represents the group. But what can the Saudis do?

For a long time Saudi Arabia was the world’s largest oil producer. The shale oil revolution changed this. Last year, we saw the US overtake both Saudi Arabia and Russia – the other big player – to become the world’s largest oil producer. Nevertheless, the US consumes a lot of what it produces. Saudi Arabia is still the world’s biggest exporter. Moreover, its vast reserves and production capacity allow it to “swing” supplies. That is, quickly alter the volume of oil it puts into the international market. In a nutshell, decreasing copious OPEC supplies would alleviate the international supply-glut and boost the international oil price.

To do this OPEC must accept a decrease in total sales volumes and a smaller market share. The burden of cutting back volumes falls predominantly on Saudi Arabia as OPEC’s biggest producer. Saudi Arabia has had experience in the past with cutting supplies whilst other OPEC members “free ride.” Meaning they benefit from an increase in prices without decreasing their sales volumes as agreed.[1]

International producers are effectively asking Saudi Arabia to do them the same favour. Just why would it do so in a competitive market?

For the moment Saudi Arabia has indeed refused to offer anyone any favours. What’s more getting oil out of the ground is very cheap in Saudi Arabia. Its oil wells have some of the lowest “lifting” or production costs in the world. This is what the graph below shows us:

BEP - IEA graph

The ultra-polluting Canadian tar sands projects are well out-of-the-money at oil prices of $50/barrel, since it costs $85 to produce a barrel of oil.[2]

The graph also shows us that Saudi Arabia can remain profitable close to $20/barrel. It could let current prices keep falling without sacrificing market share. Today’s oil price is less of a problem for Saudi Arabia than other countries where lifting costs are higher.

Yet, it is unlikely Saudi Arabia will let prices fall that far. Profits from oil sales directly support the Saudi government’s budget. Also, higher prices eventually become more important than sales volumes as profit margins tighten. For example, if I sell ten barrels at $100 each this is the same as selling a hundred at $10 each. Except that if it cost me $9 to produce each barrel my total profit is $910 in the first scenario and only $100 in the second scenario.

For now Saudi Arabia appears content to keep the price low and wait for US shale oil producers with thinning profit margins to leave the market. This strategy will cause the US shale oil revolution to lose pace and protect Saudi Arabia’s market share in the long term. However, we might see OPEC revise their policy later in 2015.


[1] It’s hard to measure exact output and countries report their own production volumes.

[2] I’ll write about the economic feasibility of the tar sands projects soon.

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Why is oil suddenly so cheap?

Between 1998 and 2008 the price of oil increased ten-fold. Everyone was talking about peak oil – the idea that production would plateau and demand for oil would outstrip supply. Skyrocketing prices would force us to replace what we put in our cars. In 2008 prices broke the $100/barrel ceiling – and then kept climbing.

What does it mean to say oil is $100 per barrel? When we talk about dollars we mean American dollars. Barrels are just a standard measure of volume (159 litres). The price of oil refers to a benchmark – a reference price. In the United States this is West Texas Intermediate (WTI), which is a blend of crude oils from diverse suppliers, which mingle at a physical hub in Cushing, Oklahoma. In Europe the benchmark is called Brent – a blend of North Sea produced crude oils. For a crude to become a benchmark there must be enough suppliers and enough barrels that the supply, and therefore the price, cannot be controlled by one player.

Crude oil needs to be processed and refined to produce the more valuable products, such as gasoline or jet fuel, that industry and consumers can actually use. So it is refineries that buy crude oil from producers. However refiners don’t all buy WTI. There are many different varieties of crude oil. An oil producer will mark up or mark down their crude oil relative to a reference price. This is why we call WTI and Brent benchmarks.

What determines this mark up or mark down? The quality of your oil. Oil can be light or heavy – a lighter, less viscous crude produces more of the more valuable petroleum products such as gasoline during the refining process. Oils are also classified as sweet or sour, which refers to the sulphur content. Sulphur is a pollutant which must be removed during refining. This is expensive to do. So the more sour your oil the more pricey the sulphur-removal process.

Oil producers are in the game to turn a profit.The WTI price affects your profitability as a producer.  For example, let’s say WTI is $100/barrel. If it costs you $70/barrel to extract crude oil from a well and you are selling it at a $20 discount to WTI then your profit per barrel is $10/barrel. (That’s a huge win.)

However, if the international price of oil – the WTI benchmark – falls $10 then you lose your profit margin.

A few years after WTI hit $100/barrel (and then went higher) it suddenly fell to $50. Multiply that by the millions of barrels being bought and sold and you can imagine there were some pretty big winners and losers. That’s the situation we have today. But why?

In less than one hundred and fifty words:

1. Since 2008 Europe underwent a recession which dampened demand for oil as economic growth dwindled and consumer spending dropped.

2. The United States is the world’s biggest oil consumer and used to drive global demand. However, over the past few years an energy revolution no one predicted took place in the US. As shale gas “frackers” began producing natural gas and pumping it into the regional pipeline networks, associated shale oil was also being produced. The best fields are called “wet” since they produce oil as well as gas, oil being more valuable. So within a few years the US went from being a huge importer to near self-sufficiency in crude oil production.

3. This meant that global oil markets were dramatically over-supplied. The supply glut happened because two of the biggest markets – Europe and the US – simply weren’t as hungry for crude oil anymore.

These days we actually talk about peak demand for oil. Technology and extraction processes get better every year, so it’s likely we will be able to produce oil for many years to come. However, production will become more expensive and, as environmental pressures weigh in, oil will become pricey enough that consumers and governments look for replacements. Even if that means buying an electric car or investing heavily in public transport.

Peak demand didn’t happen when prices skyrocketed in 2008. It might yet. Or it’s possible that demand for oil is dropping away. The international price will wane if other energy sources or energy efficiency measures become more competitive and attractive. We will have to wait and see if oil demand recovers in Europe or if Asia’s growth fills the gap.

Welcome

The perfect energy source – that is cheap, safe, abundant, reliable, environmentally friendly and producible on any scale – doesn’t exist.[i] When it comes to energy, we can’t avoid making judgment calls. Energy is policy. It is a choice.

Do we want the most stable, reliable electricity production possible? A government-sponsored nuclear industry, like France’s, makes sense.

Or is cheapest best? This is most relevant to developing economies. Coal is abundant, transportable and very cheap. And very polluting. China is the world’s biggest consumer of coal, but it still plays a huge role in countries like Germany, Poland and the US.

Or do we want to reverse climate change? If so, our society needs revolutionary rethinking. Cars, freight and planes would have to all but disappear.

Sunshine and wind are abundant in many countries and not polluting in themselves (the production of parts, installation and noise pollution aside). But who will bear cost of realising an entirely new smart electricity grid? What power generation will be used as back-up on the days the wind doesn’t blow and the sun doesn’t shine?

This blog is intentionally bipartisan. I am interested in solutions, not ideology. Developing solutions that address climate change and pollution, while also supporting development and fairness, and allowing for profitability. This requires both creative thinking and diverse inputs. We can benefit from the efficiency and dynamism markets encourage without rejecting the crucial role governments can and do play – and should, since safety is at stake.

Misunderstanding of energy issues is pervasive – exacerbated by misleading articles in the media. And our politicians struggle to promote their own energy policies, as they themselves lack clarity about the issues.

A lot of activists with worthy motivations – preventing dangerous climate change from engulfing the planet or radiation from poisoning another generation of young Japanese – make hasty suggestions about how to deal with the problems that worry them.

This isn’t surprising as energy issues are complex. They don’t conform to classic economic models. Each sector seems to have its own strange dynamic. Gas is regional. It is transported by pipelines and blighted by geopolitical manoeuvring. And it has yet to make strong in-roads into the transport fuel market to compete with petrol. It is still mainly being used by industry and for heating.

Oil is traded a hundred times more in paper than in physical barrels. This liquidity stems both from its being easy to transport as well as from strong competition. Yet, fundamental constraints affect the oil market too. The stuff of value is the refined petroleum product obtained from processing crudes. And the refineries that do this are both very expensive and inflexible, and can only be used to refine a particular crude oil.

Oil’s price level directly affects inflation and the cost of living in most of the countries that consume it. And, in the big producing countries, it often forms the backbone of their governments’ budgets, and can dramatically increase or decrease income levels.

Electricity may not be the biggest contributor to climate change, but the debate around renewable energy, particularly solar and wind power, takes centre-stage here. Electricity markets reflect their infrastructural base as electricity can’t be stored it must be consumed immediately after it is created.

The make-up of electricity systems varies greatly according to country – and within nations. For example, New Zealand’s predominantly renewable electricity mix is based on geothermal and hydropower. This is only possible because of the country’s local geographic and climatic conditions.

The often forgotten market is dirty, but abundant coal.

Coal is usually local. It is also the fuel that would suffer most if a price for carbon was integrated in its valuation. A little appreciated fact is that shifting 1% of global coal usage to natural gas would be the equivalent of increasing current renewable energy production by 11%.[ii]

A good understanding of the dynamics of the energy industry and markets is necessary if we are to be serious about addressing the global problems we face; whether these are fair consumer prices, climate change, energy poverty and access, economic and industrial growth, energy supply security or global financial stability. I’m very serious about these – although I don’t believe the solutions are easy or obvious. But we mustn’t be dismayed or dissuaded by the complexity of problems that face us. We will discuss them here.


[i] Although a cheekier analyst might suggest that energy efficiency – not wasting energy – is the cheapest fuel we have.

[ii] Data from BP Energy 2035 Energy Forecast, C.Ruhl, January 2014