We've been here before. By "here," I mean Saudi Arabia throwing its weight around in the global oil markets and triggering what we can only call a kind of reverse oil shock as a result.
The consequences were particularly visible last Tuesday, when Saudi Arabia slashed the price at which it is willing to export crude oil to the United States, even as it boosted prices to buyers in Europe and Asia. That sent the benchmark U.S. crude oil price — West Texas Intermediate — skittering down to $76.45 a barrel, a level not reached in three years.
Welcome back to the geopolitics of oil.
If you thought that crude oil prices were set simply by what is happening to the global economy — the forces of supply and demand, and the answers to pressing questions such as whether China's economy can struggle back to health — then you've simply been reading too much Adam Smith lately. Or else you have forgotten the history of the oil market.
When the magnitude of the U.S. shale oil boom began to become clear and forecasts put U.S. energy output on track to outpace that of both Russia and Saudi Arabia by 2020, it seemed as if the limiting factors were the global economy (demand) and technology (supply).
Clearly, those are still crucial, and have played a role in the deflation of what some have labeled a shale oil bubble.
The surge in production from hydraulic fracturing, or fracking, was dramatic, but Americans didn't start consuming more, in response. Why should they? A typical middle-class family is likely to be worse off today than it was a decade ago — perhaps even worse off than they were when Ronald Reagan was still president. Little wonder, then, that all that new supply hit the market with a thud, helping drive prices down more than 25 percent since last summer.
But the latest blow to the market is only partially about supply and demand. Rather, it's about how Saudi Arabia is responding to the shale oil production boom in the U.S., and the threat that boom poses to its preeminence in the world of energy production.
This isn't the first time that Saudi Arabia, with the help of its friends in OPEC, has used the cartel to keep its own market clout more or less intact and its own revenues flowing, sacrificing higher prices to that end. If it succeeds, it can dampen investor enthusiasm for shale oil in the U.S. and starve companies of the capital they need, forcing them to shut down wells in response to lower prices.
For decades, the Saudis — along with energy producing nations that were members of OPEC, or the Organization of Petroleum Exporting Countries — have determined energy prices, their ability to do so limited mostly by those global economic forces. It has been 41 years since OPEC first wielded its market clout to real effect, putting an oil embargo on sales to the U.S., Canada, Japan, the United Kingdom, and the Netherlands in retaliation for their support of Israel in the 1973 Yom Kippur war. U.S. oil prices exploded, from $3 to $12 a barrel, and gas stations began rationing fuel supplies.
Today? Saudi Prince Alwaleed bin Talal describes shale oil production in the United States as "an inevitable threat" to Saudi Arabia and OPEC, eating into demand for OPEC member nations' exports and their revenues. What the prince didn't even mention is that other non-OPEC members, like Russia (already a giant oil and natural gas producer) and China also are investigating shale reserves, further undermining OPEC's pre-eminence, and its control over supplies and prices.
Saudi Arabia is in an interesting position. Its proven oil reserves are still the world's second largest, and it is home to the world's largest oil fields. But they are aging, and there are plenty of questions as to whether their production levels may have peaked. The U.S. already has overtaken the Saudis as the world's largest oil producer. Their window of opportunity to reassert some degree of control has been closing rapidly.
On the surface, it seems as if driving prices lower is counterintuitive, especially given the budget issues the country faces: since the Arab Spring in 2010, its spending on domestic programs has soared as it tries to ward off any similar discontent among its own population. Higher oil prices helped to finance that, but then, as the threat to its market share from shale oil grew, Saudi Arabia boosted output in both 2012 and 2013, attempting to drive costs lower while still continuing to finance its costly budget programs.
The last time the Saudis tried this tactic was back in the 1990s, when an influx of new supply from Latin America threatened its pre-eminence. It's noteworthy, then, that the Saudi oil minister is making a visit to Venezuela — the cartel's weakest member, fiscally — this week. Perhaps drumming up support for a cartel-wide initiative?
Saudi Arabia fought the same battle in the 1980s, less successfully, arguing for OPEC members to limit production quotas. When OPEC members reneged on their commitments, the Saudis acted unilaterally, slashing their own output in 1985 to a quarter of the level it had been at five years earlier. When that didn't work, they'd try something different: flooding the global markets with cheap oil. The glut remained for years, with oil prices struggling to move north of $10 a barrel. The tactics wreaked havoc on Saudi Arabia's own finances, but they also made North Sea oil economically unprofitable to produce — and convinced OPEC members to fall in line.
Once again, Saudi Arabia has acted unilaterally, startling fellow OPEC members, many of whom already are squabbling over what they believe the "right" price for oil should be. With a cartel meeting scheduled to take place in Vienna at the end of the month, there's a lot at stake, including the short-term prospects for the U.S. shale oil and gas industry.
Long term, however, the Saudis may be building their strategy on shifting sands: The technology that made shale oil development possible in the first place is becoming less expensive every year — and every year that passes causes the Saudi reserves to become that much older and less capable of being boosted in response to a perceived market threat. Cartel power and geopolitics may yet fall victim to another factor influencing supply and demand: demographics.
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