Saudi Arabia to Continue Fueling Low Crude Oil Prices

Issue: One of the key driving forces behind falling crude oil prices is the Kingdom of Saudi Arabia’s (KSA) ability and willingness to endure the negative effects of low prices in the short-term as it seeks to benefit substantially in the long-term. With an estimated $750 billion in foreign reserves and extremely low production costs, the KSA can sustain itself on prices as low as the $20 per barrel (bbl) range without suffering from any major economic setbacks. Although it does not control the global oil price alone, the KSA and its Gulf State allies account for nearly 30% of the global crude oil market and it is now using that leverage to minimize the impact of North America’s shale oil “boom”, as well as inflict harm on the economies of its competitors in the world oil market.

Impact: The price of Brent crude oil hit $45.19 this week, its lowest mark since 2009. While a price this low hurts the economies of every major oil producing country including the KSA, other producers such as Iran, Russia and Venezuela require a much higher “break even” price than the Saudis do, and the cost of production for shale and gooey tar sands oil flooding the market from the U.S. and Canada is much higher than it is for Saudi crude. Since the KSA can profit from selling a cheaper product at a lower price than any other country in the world, it can afford to sit back and watch the price of crude oil drop while dipping into the coffers of its vast reserves to make up the losses. Meanwhile, other oil producing countries have only two options: they can either continue selling their products at unprofitable prices or cut back on production and risk losing market share to the Saudis.

Next Steps: Even with oil prices dipping to a six-year low, the KSA has maintained that it will not decrease production anytime soon. According to Saudi Oil Minister Prince Ali al Naimi, “[Saudi Arabia] is going to continue to produce what we are producing, we are going to continue to welcome additional production if customers come and ask for it…[That] position we will hold forever, not [just] 2015”. While this is almost certainly an empty promise, as oil accounts for about 40% of the KSA’s total GDP and its 2015 budget is registering a $38.6 billion deficit due mostly to the expected low oil prices throughout the coming year, the Saudis can afford to ride out the low prices for at least the next 3-5 years without suffering any kind of major economic setbacks.

More information below:

The impact of oil on the Kingdom of Saudi Arabia’s (KSA) budget:

The KSA retains the largest slice of global crude market share at 15.11% according to RBC Capital Markets. Add in the Saudi’s Gulf State allies-the United Arab Emirates (5.65%), Kuwait (4.03%), Qatar (2.98%) and Oman (1.63%)-and the total market share rises to 29.4%. They also represent about 40% of global production and 80% of all reserves. Furthermore, these countries all have nationalized oil making it very easy for them to control exactly how much oil they produce. As the largest players in OPEC, these countries alone can basically set production rates for the rest of the Member states. If other countries choose to decrease production while the Gulf States maintain or raise their production, they risk losing market share. The inverse is also true, leaving the Gulf States vulnerable to losing market share if they decrease production. Since they are all Sunni Arab controlled countries, their interests are often aligned and they will generally act in unison by following the KSA’s lead. So, while the KSA does not control global oil prices alone, it still has the largest influence on prices because it can take the quickest actions which will have the most immediate effect on the price of crude oil.

The KSA also has a relatively low “break even” rate of $89-93 per barrel (bbl) compared to higher rates for Iran ($136/bbl), Venezuela ($121/bbl) and Russia ($102/bbl). The KSA can make a profit by selling its oil as low as the $20/bbl range, however their budget is based on oil at around the $100/bbl range, which means it will experience deficits at lower prices. A $38.6 billion deficit has already been factored into the KSA’s 2015 budget, but with an estimated $750 billion in foreign reserves the Saudis can easily afford a deficit that size, or even larger, for 3-5 years. This seems precisely what the Saudis are prepared to do; according to Saudi Finance Minister Ibrahim al Assaf, “…over three to five years...The (economic) depth we have…will be enough until prices get better. We have the ability to endure low oil prices over the medium-term.”  Oil accounts for about 90% of the KSA’s export earnings, 80% of government earnings and close to 40% of total GDP.

For the KSA, the long-term benefits are enough to offset the short-term negatives. They can “punish” rival countries such as Iran and Russia who economically support the Assad regime in Syria, cannot afford the current oil prices and are already suffering as a result of U.S. and E.U. sanctions. It can also make shale and gooey tar sands oil production in the U.S. and Canada unprofitable, forcing them to

lose market share or push them out of the market altogether. U.S shale gas break even points are highly variable ranging from $40/bbl-$160/bbl, but most American-produced shale oil requires prices to be higher than $70/bbl in order to make a profit. Synthetic oil produced in Canada is even more costly with a full quarter requiring prices above $80/bbl. The U.S. alone has added roughly 4 billion barrels of crude oil exports per day to the global total of about 75 billion since 2008, and as of 2014 it had climbed over both the KSA and Russia as the largest oil producing country in the world.

Elasticity of oil demand:

The elasticity of oil demand for the world’s largest economies and on a global net basis is very small, by some estimates as low as -.25. This is due to the fact that responses to changing oil prices that would reduce demand are timely both on the personal and the political levels. For example, on the personal level, if an individual needs their car to get to work their demand for gas will not change as the price of oil fluctuates. That individual will still have to go to work as the price rises, and will not travel farther than work if the price falls. Over time, however, the individual can make changes that will reduce their demand such as moving closer to work or purchasing a more fuel-efficient vehicle. But, the individuals to feel the greatest impact from an increase in oil prices are those least likely to have the means to invest in things like a new apartment or a new car because they are those at the bottom of the economic spectrum. Likewise a country can cope with an increase in oil prices with greater fuel-efficiency standards for vehicles, but because changes in policies like that take such a long time to be implemented the effects on overall oil demand occur a long time after a change in price. So, for developed countries, demand in response to a change in oil prices is extremely small because there is little that an individual or a country can do to in the short term to change oil consumption and the small changes that will take place happen over a length of time. For developing countries, the price elasticity of demand for oil is theorized to be even lower than that of major developed countries, by some estimates as low as -.07 in the short term.

There is no way to predict accurately just how much a 50% drop in oil prices would affect global GDP because it is impossible to predict how the impact would be distributed and how individual countries would

respond to such an event. There is a theory that every 25% drop in oil prices has a roughly $1 trillion stimulus effect on the global economy, so a 50% drop would represent a $2 trillion stimulus. Considering the U.S. is approximately 25% of the world’s economy, it would theoretically experience a $500 billion (one quarter of $2 trillion) net positive impact from a 50% drop in oil prices. These numbers, however, are mostly conjecture. Generally speaking, the impact on GDP of a drop in oil prices will be a net positive on a global basis since there are more consumers of oil than there are producers. For individual countries, those that import more oil than they produce, like the U.S. and China, will generally see a positive effect. Conversely, those countries that export more oil than they consume, like the KSA and Venezuela, will typically experience a negative net impact. The few exceptions are for those countries that rely heavily on commodity–based economies, like Brazil, and countries that engage in large amounts of trade with oil-producing countries, such as Poland (trade partner of Russia), which will experience net negative effects from a drop in oil prices.