Saudi Oil Price Theory Price volatility in the global crude oil market has been a forefront issue

in United States energy policy. Since the oil price shocks of the 1970s and 80s, growing dependence on oil imports abroad has forced the U.S. to take an active role in preventing large price swings in the global crude markets. In the pursuit of stable prices, the U.S. has looked to Saudi Arabia to mitigate these concerns. As the largest producer of crude oil since the 1950s and the leading member of OPEC, Saudi Arabia holds 20 percent of the worlds total proven reserves and supplies 12 percent of the worlds total demand annually (BP Statistical Review, 2011). Thus, the U.S., like many other consumer-based countries, has operated under the premise that Saudi Arabia can influence global crude prices by raising or lowering production, thereby dictating crude prices through the fundamentals of supply and demand. This understanding of crude pricing, however, relies on the key assumption that Saudi Arabias level of production grants them the ability to act as a price-setter in the global crude market. This assumption is simply not true. Saudi Arabia has never directly controlled the price of crude as its fluctuating production levels have had very limited effects on price trends. In addition, various bottlenecks in the production process, mainly the worlds refining capacity, have restricted Saudi Arabias ability to leverage production in altering total world supply. This is supported through the various roles Saudi Arabia has played in the global crude market. Under its OPEC administered price system, Saudi Arabia could not prevent its competitors and fellow OPEC members from following spot market trends at the cost of Saudi price policy; while under the formula-based pricing system, Saudi Arabia could not affect crude prices, as refining capacity failed keep pace global demand, restricting Saudi output.

Rogers 2 The myth of Saudi Arabias price-setting power has been built upon OPECs control of production throughout most of the 20th century. As OPEC member-states nationalized regional upstream development during the 1970s, they transformed the structure of the global crude market from a one based on vertical to horizontal integration. Equity participation and nationalization profoundly affected the structure of the oil industry. Multinational oil companies lost large reserves of crude oil and found themselves increasingly net short and dependent upon OPEC supplies (Fattouh, 2011: pg. 17), writes Bassam Fattouth. With crude oil demand increasing throughout the 1970s at annual increase of more than 3 million bpd, OPECs control of upstream production gave it considerable leverage in the price discovery process (pg. 20). By the late 1970s, multinational oil companies had to compete against independent refiners, state oil companies, trading houses, and oil traders for OPEC crude, creating a crude sellers market. However, as OPECs position in the market strengthened, OPEC did not establish a formal pricing system, allowing oil refiners to purchase crude at a variety of prices. Some multinational oil companies still purchased oil through posted and buyback prices agreed to by OPEC in previous long-term contracts, while independent refiners had to compete in third party markets under formal government selling prices. In response to these price differentials, Saudi Arabia created the OPEC Administered Pricing System, which effectively gave itself the ability to set global oil prices (2007: pg. 8). Under this new system, OPEC member countries set their crude prices in relation to the price of Saudi Arabias crude Arabian Light. The price differentials of member crudes were based on crude variety and transportation and production costs, bringing uniformity to OPEC prices. Armed with standardized prices and large market share, it seemed Saudi Arabia and the rest of OPEC were set to control global prices. Yet Saudi Arabias enactment of a reference price system could not prevent the rest of

Rogers 3 OPEC from disregarding Saudi price controls, as Saudi prices encouraged production levels favorable to producers with higher marginal costs. Lower production levels from higher prices incentivized producers to produce at levels that minimized their marginal costs instead of raising overall prices (Mabro, 1992: pg. 12). Producers pursued this policy because the total cost of production generates different marginal costs for producers with varying amounts of reserves. The sunk costs of upstream development and the fixed costs of downstream development are spread over the amount of total reserves produced. Therefore, producers with low levels of proven reserves will have high marginal costs, and vice-versa. Higher marginal costs, in turn, incentivize producers to pump crude at the fastest rate possible to minimize the fixed costs of production (pg. 13). However, producers risk flooding the market with crude, pushing prices downward, and thereby defeating the purpose of lower marginal costs. Playing off of Saud Arabias price regime provided high marginal cost producers with the benefit of both moderate prices and production levels that maximized profit margins, forcing Saudi Arabia to bear the cost (pg. 13). The Saudis low marginal cost incentivized Saudi Arabia to offset the production levels of other OPEC producers in order maintain moderate prices, which sustained sufficient marginal revenue and prevented the market from creating substitutes that would not be affected by price volatility. The price swings resulting from the Iranian Revolution and Iran/Iraq war in 1970s and 80s illustrate this concept perfectly. The OPECs response to the spot market during the great price increases in 1978 and the subsequent decreases in 1982 shows its complete disregard for Saudi price controls, which attempted to avoid market volatility. Over the course of September 1978 to January 1979, Iranian output decreased from 6 million bpd to 700,000 bpd, and in February 1979, Iranian exports were suspended all together (Roberts, 1984: pg. 19). Even as

Rogers 4 Saudi Arabia tried to offset the losses in output through higher production levels, total production fell by at total of 3 million bpd, or 4.7 percent of total OPEC production (pg. 19). In response to excess demand, spot prices increased 40 percent by January of 1980, rising from 12.5 to 22.5 dollars per barrel (pg. 21). During this period, Saudi Arabia agreed to only raise its reference price by 5 percent in order to keep volatility at a minimum. However, Saudi Arabias attempts to urge moderation were largely ignored The result being a wide range of price increases from Saudi's $l/b to up to $3.75/b by the African producers (Algeria, Libya and Nigeria). Even Gulf producers such as Abu Dhabi, Qatar, Iran, and Kuwait set their surcharge at $1.80/b (pg. 25), writes Steve Roberts of the Oxford Institute for Energy Studies. As the Saudis price increased marginally at about 5 percent over the course of 1979, OPEC producers like Ecudor, Libya, Abu Dhabi, and Qatar increased prices by 9.31, 11.31, and 13.15, and 14.03 percent respectively, mimicking the spot price market abroad (pg. 26). Additionally, the standard deviation between prices differentials among OPEC producers increased significantly from 3.29 percent in February 1979 to 15.42 percent in November 1979, proving how OPEC producers completely ignored Saudi price moderation in light of higher profit margins (pg. 26). OPEC producers pursued the same strategy as crude prices fell throughout 1981 and 1982. As Saudi Arabia increased production by 2.5 million bpd to offset the fluctuating production of Iran and Iraq, excess supply began to build as worldwide demand decreased from 66 to 53 million bpd between 1978 and 1982 (pg. 31). This resulted in decreasing crude prices. The spot market responded first by decreasing prices by 8 to 10 dollars per barrel in mid 1981 (pg. 33). Spot prices were set just below the Saudi reference price as Mexico, Egypt, Britain, and the Soviet Union set their prices 2.5, 3, 3.5, and 5 dollars below Saudis crude respectively (pg. 37). The undercutting of Saudi Arabia transferred market share from OPEC to independent

Rogers 5 producers. Between 1979 and 1982, OPEC production fell from 32 to 17 million bpd while the rest of the worlds production grew steadily from 22 to 38 million bpd (pg. 38). This loss in market share forced OPEC producers to lower prices compatible with Saudi Arabia even though smaller producers like Ecuador and Nigeria fought hard to sustain high prices. However, when OPEC prices were reunified, OPEC producers undercut the Saudi price at a slightly lesser margin than the spot market, as the average OPEC price was 1 percent under the official Saudi price. According to Steve Roberts, OPEC producers pursued this policy for larger share of the market and hence the potential for maintaining their production despite the contraction of worldwide production. [Producers] effectively passed on the production cuts to [their] competitors (pg. 32). This goes to show that while Saudi Arabia may try to stabilize price by changing output and restraining its price, global prices were first set by the spot market while OPEC producers followed in order to mitigate marginal cost. OPECs marginal cost pricing strategy devastated Saudi Arabias price setting power. Saudi Arabia could no longer absorb OPECs price differentials without realizing the benefit of moderate prices. Therefore, Saudi Arabia disbanded the OPEC pricing system, giving the price discovery process back to the market under formulaic pricing. Here, Saudi Arabias price setting abilities must be reassessed. According to Robert Mabro of the Oxford Institute of Energy Studies, a market-oriented pricing system provides Saudi Arabia with a limited effect on crude prices (Mabro, 1992: pg. 4). Only through fluctuations in production levels can Saudi Arabia trigger excess supply or demand, moving market prices. But as Mabro points out, a price setters ability, will have much to do with what can be achieved, not with what one can dream about in an idealized world divorced from reality (pg. 9). Fluctuating production levels, therefore, depend upon excess spare capacity. Excess

Rogers 6 spare capacity grants Saudi Arabia the leeway to determine production levels outside market conditions, thereby distorting prices. However, investments in more capacity are costly and raise the marginal cost of every barrel produced. In addition, the benefits of increased capacity may not be realized immediately. These liabilities beg the question: do the costs of controlling crude supply and demand outweigh the subjection to changing market conditions? The answer lies in the price volatility generated from bottlenecks in production due to the lack of investment in new capacity over the past 30 years. Bottlenecks in production have been the main cause of price volatility as the nature of capacity investment deters producers from taking on the risks of increasing capacity, spurring price volatility. Because investment in new capacity is irreversible and holds large sunk costs, producers must be guaranteed profit margins off their investment. Yet since, six to eight years generally elapse between the discovery of new oil in a midsize field and the start of crude production (Maugeri, 2006: pg. 2), new investments might not respond to the original supply and demand imbalances, leaving producers with the cost of spare capacity. In light of these risks, producers find it more profitable to under-invest in new capacity which tightens the market, making the market more susceptible to price volatility. This creates a market unresponsive to supply and demand imbalances, characterized by periodic price swings. Refining capacity is more susceptible to crude bottlenecks, making upstream development less relevant in the pricing of crude oil. Bottlenecks take hold in the refining process because refiners facilitate the meeting of supply and demand in the market. Refiners must process various types of crude oil into oil products while gauging the amount of crude needed to meet demand. Incomplete information in forecasted demand and under-investment in refining capacity can cause bottlenecks in the refining process. Incorrect assessments of

Rogers 7 consumer demand can either leave refiners with large amounts of inventories, significantly decreasing the price of crude, or leave refiners scrambling for more supplies as product prices increase. The 1998 oil crisis highlights this point. In 1997, the IEA forecasted worldwide demand would increase by 1.5 million bpd as the Japanese and Chinese economies grew at rapid rates. However, recessions in both China and Japan throughout 1998 decreased worldwide demand. Producers unknowingly over-supplied the market with 1.3 million bpd, forcing refiners to take on 117 million barrels of oil inventories over a 90-day period. Large inventories pushed the futures market into a contango effect, which flooded inventories with more crude, pushing prices down from 24/b in 1997 to 12.50/b in 1998 (Mabro, 1998: pg. 8). Likewise, under-investment in refining capacity can have the reverse effect, pushing prices upwards, as refiners arent equipped with the proper facilities to process various crudes into specific products. Leon Maugeri, Director of Strategic Operations at ENI, asserts low crude prices in the 1980s and 1990s led to under-investment in refining capacity, which caused the 21st century price increases as refining capacity couldnt meet demand. Maugeri notes that the U.S. hasnt produced a single refinery since 1982 and currently holds a 20 percent refining deficit, as refineries have barely kept pace with the U.S.s increasing environmental regulations. Additionally, Saudi Arabias excess spare capacity increased by 2 million bpd between 2005 and 2010. Maugeri notes that these increases were in Saudis Heavy crude, which could not be processed by American refiners (Maugeri, 2006: pg. 3). Price changes resulting from refining-based bottlenecks make production fluctuating price changes obsolete. Saudi Arabias output alone is seemingly irrelevant as refineries mitigate both crude and product demand. Only indirect price changes through excess capacity investment can allow Saudi Arabia to set price trends. Even then, refineries can simply adjust supply and

Rogers 8 demand through inventories and refining capacity, smoothing market disturbances. In todays market-oriented system, pricing ability solely lies in a series of bottlenecks, mainly in refining capacity, caused by under-investment and misinformation not direct price changes reminiscent of the 1970s. The era of administered prices are over, and the myth of Saudi Arabias pricesetting power should be put to sleep. The market has bound Saudi Arabia to consumer demand. If only the U.S. would acknowledge this fact.

Work Cited Jabber, P. 1978. Conflict and Cooperation in OPEC: Prospects for the Next Decade. International Organization, Spring, 1978, Vol. 32, p.377-399

Rogers 9 Fattouh, B. 2007. OPEC Pricing Power: The Need for a New Perspective. Oxford Institute for Energy Studies. Fattouh, B. 2011. Anatomy of the Crude Oil Pricing System. Oxford Institute of Energy Studies. Roberts, S. 1984. Who Makes the Oil Price: An Analysis of Oil Price Movements 1978 1982. Oxford Institute for Energy Studies. Mabro, R. 1992. OPEC and the Price of Oil. Oxford Institute for Energy Studies. Mabro, R. 1986. OPEC and the World Oil Market: The Genesis of the 1986 Price Crisis. Oxford Institute for Energy Studies. Mabro, R. 1998. The Oil Price Crisis of 1998. Oxford Institute for Energy Studies Okogu, B. 1987. The Spot Market, Inventory Management and Crude Oil Price Behavior, 19751983. University of Oxford. Faculty of Social Studies. Maugeri, L. 2006. Two Cheers for Expensive Oil. Council on Foreign Relations. April 2006.