why are the Saudis raising oil output?

Saudi Arabia to the rescue

Saudi Arabia announced recently that it is upping the amount of oil it produces.  It’s doing so to replace the portion of Libya’s normal output of 1.6 million barrels a day being lost during the current political struggle there.  The Saudis will doubtless be joined by other OPEC nations who will increase their production as well, although these other countries may not choose to identify themselves.

Even assuming the total number of barrels reaching the market is unchanged, the world faces a short-term logistics issue.  The Saudi crude needs more processing than Libyan oil.  It has extra sulfur (corrosive and a pollutant) that needs to be removed, for one thing.  And it contains more large molecules that need to be “cracked,” or broken down chemically to yield higher value-added products like gasoline or jet fuel.  The quality difference is a particular problem for Italy, the traditional buyer much of Libya’s oil.  (Italy seized Libya from Turkey in a war about a century ago and held it as a colony until after World War II.)  The country’s refineries haven’t seen the need to spend money on the expensive equipment required to process lower-quality Saudi crude into stuff customers can use. Nevertheless, they’re under severe political and market pressure to deliver refined products.  The resulting scramble for easy-to-refine crude is one reason the price of high-quality North Sea oil has risen so much.

Provided governments don’t decide to “help” the process along with new regulations, oil companies should readjust the world’s refining and distribution networks to restore the flow of gasoline, naphtha and jet fuel to something akin to the pre-Libyan-revolution normal within a few months.  I think there’s a very good chance of this happening.

why add production?

That doesn’t mean I don’t see a secular upward trend in the price of oil, because I do.  In this post, however, I only want to address the narrow question of why Saudi Arabia is acting to hold down oil prices, even though a $1 a barrel rise in the cost of crude puts an extra $3 billion a year into the royal treasury.

the iron law of macroeconomics: substitutes determine pricing

The answer is pure microeconomics.  Saudi Arabia, like many OPEC countries, has enough oil underground to last for well over fifty years at its current production rate.  It could easily have a hundred years’ worth.

Most of those barrels will only have value if petroleum remains the world’s fuel of choice in 2060…and in 2100.  So Saudi Arabia certainly doesn’t want world governments worrying about the dependability of oil supply and starting programs of serious research on possible replacement fuels.  Nor does it want dramatic real (that is, inflation plus) increases in the price of oil that might cause consumers to start to conserve.  Saudi Arabia doesn’t want to make waves.  It just wants to keep taking its $800 million + check to the bank every day.

conservation potential

Conservation could be a serious threat to OPEC revenues.  Look to the United States, which is the low-hanging fruit in the conservation department.  We have 4% of the world’s population but use about a quarter of the world’s oil (we consume about 3.7 tons of the stuff yearly for each man, woman and child in the country).  We’re the only developed country without a coherent national energy policy.  We’re practically alone in not taxing oil heavily to discourage use.  True, we no longer artificially depress the price of oil as we did in the Seventies.  Nor do we have quotas that limit imports of fuel-efficient cars, as we did in the Eighties.  But that’s not much.  The Saudis have a strong economic interest in us not waking up.

history shows what sharp price increases do

We’ve seen during the oil shocks of the 1970s what happens when oil price skyrocket.  Crude oil prices, which were under $2 a barrel in the 1960s, quadrupled in the early 1970s, declined somewhat and then more than doubled during 1978-80 in the wake of the Iranian revolution.

What followed was a period of global economic stagnation and then–crucially from an oil producer’s point of view–a twenty-year period of oil price decline.  At its nadir, crude had given back in real terms virtually all its gains from the 1970s.  So OPEC had a few years of riches, followed by two decades of budget deficits.

Conditions could actually have been worse for oil producers, had it not been for Saudi Arabia.  Had the Saudis acted unilaterally to temper price increases by adding to output, prices might have otherwise stayed high enough for long enough during the late Seventies-early Eighties to force permanent changes in consumption. Those billions of barrels of oil still in the ground might have become worthless.

As it turned out, however, and especially in the US, governments quickly lost interest in substitute fuels and in conservation measures as oil prices began to slide.

Today, Saudi Arabia is just doing what it has been doing for the past thirty years +, taking the role of the “swing producer” to keep real increases in prices under control.  This behavior may have its altruistic aspects, but, given its vast amounts of untapped oil, Saudi Arabia is clearly acting in its own economic interest.

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