Oil prices declined by 16 percent since the June high. Why are oil prices declining? What’s the role in the decline? While the oil price has fundamental and political components, are the Saudis trying to hit both? Has Saudi Arabia become more pivotal economically and politically and taken too much risk?
Oil prices for both American West Texas Intermediate and European Brent have been falling, despite all the threats from the Islamic State of Iraq and Syria and all the sanctions in the world. Without those political features, oil prices would have fallen more.
WTI futures dropped below $90 a barrel this week, which is a 17-month low. Brent futures fell to nearly $92, which is its lowest low in more than two years. More declines are expected.
What are the factors that have recently driven the oil prices down? Some factors have to do with fundamentals, while others are political.
One factor is that the U.S. oil output has increased more than expected due to oil shale fracking. It increased by almost three million barrels since 2011 and this production could have been another 1.5 million barrels per day higher, but booming U.S. oil and natural gas production overwhelmed the nation’s pipeline and rail-tanker infrastructure.
Moreover, the U.S. output is expected to increase considerably more by 2020. This implies that U.S. oil imports have significantly declined which increased competition in the global oil market. U.S. imports’ share in total oil consumption has dropped to 40 percent, down from 60 percent more than a decade ago.
Moreover, the growth of U.S. production has been the main factor counterbalancing the supply disruptions on the global oil market. Half of the recent increase in world production came from U.S. and Canadian oil fields.
Another factor is the slow global economic growth in many major economies has reduced the demand for oil, consequently dropping oil prices.
The decline from 10 to 13 percent to near-7 percent in annual economic growth in China has placed significant pressure on oil prices, especially since China accounts for about half of the growth in the global demand for oil which reached a record 92.26 million barrels a day in June. A third factor is that Saudi Arabia is switching its oil policy from the swing producer that guards oil prices to a market share protector. It has disclosed that in the face of higher competition in the oil market, it will protect its market share, which means it will increase its production without much regard to declines in the oil price.
When it played the role of the swing producer, it decreased its output to prop up oil prices. Given its economic fundamentals, Saudi Arabia can afford protecting its market share now. Its government has paid all of its debt to local banks several years ago and higher oil prices have brought consecutive surpluses to its budget.
Moreover, the current oil prices are still higher than the breakeven level that balances its budget with expenses. I should remind the Saudis that the netback pricing policy that they followed in 1985 dropped the oil price from $40 to $10 within a year. A market share-maintaining policy can also negate the role of OPEC as a global price regulator.
Based on this analysis, this policy brings greater political components to oil prices. First, the new oil price reduction policy could be part of a greater deal between Obama and the Saudis to achieve certain goals in the Middle East and in the world.
They both have attacked ISIS and may want to sharpen the sanctions to inflict more damage on Russia, which depends on oil and natural gas exports as the primary source of foreign exchange. The Saudis may have another ulterior motive, which is to slow down the march of oil shale fracking by pricing this source of oil out of the market under the pretext of maintaining market share.
I do not have a precise price for oil coming from fracking but the Saudis may have figured it out and may stop there when oil prices from conventional sources reach there. But the red line for this Saudi Arabian policy is the breakeven oil price for their budget balance which is estimated to range from $82 to $90 a barrel.
They cannot go much below the breakeven price without increasing production since the demand for oil is inelastic, which implies that decreases in prices lead to declines in oil revenues without changes in production.
But between now and 2017, and even more so if the time is extended to 2020, the Saudis will find that their market share policy may send the oil price well below their red line if they keep increasing production and as the U.S., Canada and others bring another batch of three million barrels a day to the market.
In sum, the Saudis should eventually have an oil revenue problem as the increases in production will not be able to make up for the decreases in prices, particularly as production hits maximum capacity. Then the alarm bell will sound that Saudi Arabia is slipping into deficit much sooner than expected because of its ambitious spending program which is designed to appease its people after the Arab Spring.
The Saudis are taking too many risks at the same time. I should also add that if anyone is able to kill OPEC with one shot, it will be the Saudis.
What all this means is that we are coming to a new era that will substantially lead to sizable decreases in oil and gasoline prices. It is estimated that every 10 cent drop in the prices of a gallon of gasoline puts $13 billion dollars in the pockets of American consumers annually.
This should help, since all of us in the United States have suffered from low wages and salaries and meager 1.5 to 2 percent raises.
Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at [email protected].