Beggar Thy neighbor: Saudi Arabian Strategy By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

May 7, 2015 | Posted by bobbysrinivasan << back to blog

The global oil price is now witnessing volatility in prices not seen before for well over a decade. The WTI (West Texas Intermediary) crude touched a low of around 40 dollars a barrel a few months ago is now trading around 60 dollars. A hefty 50% jump in prices, similarly the Brent crude oil, has made similar gains from its lows and is currently trading at 67 $ a barrel. A while ago when the oil prices were heading south the Saudi Arabian oil minister stated that regardless where the oil ends up, be it 50 or 40 or 30 or 20 dollars a barrel, it has no intention to cut its production and not loose their market share. In the past Saudi Arabia is known to be a swing producer cutting production whenever it needed to stabilize the prices which they did during the Asian financial crisis of 1997. The market has just heard that they have increased their daily production to 10.3 million barrels, its highest level on record.

Although this decision to produce more is not economically justified, which in fact may result in a lower profit margin. This is being offset by maintaining and marginally increasing its market share. There is the other benefit due to beggaring their neighbor policy. Saudi Arabia is hurt less by lower oil prices as compared to its competitors. This is a conversation between a student and his professor.

Student: Professor, Is Saudi Arabia crazy? Why would they increase their daily production?

Professor: You should see the complete picture before you rush to reach any conclusion. The current oil prices are of course depressed. There are reasons both from the demand and the supply side. Look at the supply side. There has been a significant development of American Shale oil and the Canadian Tar sands as well as new supplies from Russia, the Artic, Brazil, Central Asia, Africa and growing volumes of shore oil around the world. There has also been unexpected resumption of oil production in Libya, Nigeria, South Sudan and Iraq as well as the possibility of a future boom in Mexican oil production on the demand side. The slowdown in growth in both China and Europe has meant a decreased demand for oil. Technological advancement, leading to increased energy efficiency have had a negative effect on the global demand for oil. Given increased supply, reduced demand Saudi Arabia is enjoying the benefits.

You see Saudi Arabia is smiling its way to the bank. According to Reuter the marginal cost of producing one barrel of oil stood at between 70 and 77 dollars from the shale oil while the Middle East on shore oil production is between 10 and 17 dollars a barrel. Phil Leech of “capital As power” says “The cut in prices clearly harms all producers by reducing the amount of profit per barrel, but it certainly gains some more than others. In particular it is far more damaging to several international actors most of whom happen to be strategic rivals to either to Saudi Arabia or its closest ally namely the US (ex. Russia, Iran, ISIS Levant).

Student: Professor, it is very convincing. I thought the global oil market was a perfect market in which competition contributed to the price discovery. I also believed that Saudi Arabia is a naïve country. Now I understand that they are strategist big time. Thanks Professor.

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