Can Saudi Arabia Flood the Market?

Saudi Aramco Headquarters in Dhahran

The second part of Andrew Scott Cooper’s Tehran Bureau series is now available (click HERE). It’s worth a second look. His statements are in quotes.

Fast forward to May 2012 and oil is still priced at over $100 per barrel, Iran’s nuclear program is moving forward, and the Saudis have not moved against the oil markets.

The Saudis haven’t moved against the oil markets? Last year they pumped about 8.5 million barrels a day (b/d). Because of disruptions and anxiety surrounding a possible strike on Iran, they are now pumping 10 million b/d, all in an effort to push down prices. Cooper says the Saudis might flood the market in order to turn the screws on Iran. But the Saudis are already flooding the market: according to the International Energy Agency, supply is now outpacing demand by 1.5 million barrels on a daily basis–roughly the number by which Riyadh increased output this year.

They’ve also promised to keep producing at this rate for the near future. And Iranian authorities aren’t happy about it. On May 29, Iran’s OPEC Governor Mohammad Ali Khatibi blamed Saudi Arabia for producing too much. “Increasing production by some OPEC members, especially Saudi Arabia, will create instability in the market and will likely lead to a serious decline in oil prices which undermines OPEC’s goals,” he said.

We can’t give the Saudis all the credit. Oil prices are declining because the global economy is sputtering. But where would prices be without Saudi Arabia’s additional 1.5 million barrels a day? Brent–the European benchmark that Saudi oil prices are tied to–now sits at $98. The Saudi target price might be $100, according to Oil Minister Ali Naimi, but there’s no indication Riyadh will cut back production soon.

Iran, and not Saudi Arabia, was OPEC’s preeminent power broker [in the mid-1970s]. Although the Shah was a U.S. ally, he had antagonized Washington by engineering the 1973 oil shock that led to the swamping of Western economies with debt, unemployment, and inflation, and sparked fears of banking collapses and the bankruptcy of NATO allies in southern Europe.

Iran was not the “preeminent power broker” of OPEC in 1973 even if it was a major producer. Saudi production was still higher that year. And the Shah did not “engineer” the 1973 oil shock. King Faisal of Saudi Arabia, who was known for being preoccupied with the Palestinian condition and a staunch opponent of Zionism, led the embargo effort after the U.S. sided with Israel in the Yom Kippur War (see Daniel Yergin’s account in Chapter 29 of The Prize).

The Shah joined OPEC members in hiking the posted price of oil in October 1973. But he kept production high, sold to the U.S. and Israel, and did not join the embargo. Washington was certainly disappointed with the Shah because he refused to push down prices. But it was the embargo—combined with the devaluation of the dollar in 1973—that shook the market, hurt Western economies, and drove inflation. The Shah cashed in. He did not create the crisis.

In the wake of the Arab Spring unrest across the Middle East, the Saudi government announced that it planned to increase state spending by at least one third and pump more than $130 billion back into the domestic economy. This raises the risks of monetary overheating and inflation. An estimated $6 billion will be spent on foreign study scholarships alone. Anxious to stabilize the emerging regional order, the Saudis have poured at least $5 billion in loans and grants into Egypt to prop up that country’s foreign currency and military government. Billions more are being spent to combat Iran’s vaulting ambitions in Lebanon and Iraq. Then there is the $60 billion arms deal concluded with the U.S. in 2010 — the biggest of its kind.

Who will pay for the billions in welfare subsidies and high-tech weapons?

The Saudis aren’t facing a massive budget crunch. The $130 billion package announced by King Abdullah last year, for instance, includes housing and other projects that will take the better part of a decade to complete. Monetary aid given to foreign countries is also a slow-going process (if it is ever delivered). Just ask the Egyptians, who only recently secured a Saudi aid package of $1.5 billion, even though it was promised last summer. The arms deal is another example of gradual spending mistaken for splurging. The deal may be worth $60 billion but that covers the life-cycle of the equipment sold. That sum will be spread out over the next decade.

In the meantime, Saudi coffers will only grow. Last year they posted a budget surplus of $81 billion even though the King’s expanded welfare programs had already increased wages and benefits for many Saudis. I can’t guess what Saudi Arabia’s budget surplus will be this year. But for the first six months of 2012, they pumped 10 million b/d when the market’s asking price hovered well over $100. I bet the 2012 surplus will be significantly higher than 2011.

Iran should be more worried about declining prices than Saudi Arabia. The IMF now estimates that Tehran needs $117 a barrel in order to balance its budget. Reuters, citing national authorities and the IMF, says Saudi Arabia’s break-even price per barrel is only $71.

As I noted in my column earlier this month, the Saudis are not only producing oil at full capacity, they are also stockpiling much of their surplus production. Until they decide whether to hold on to it or flood the market with it, the Saudi oil sword remains sheathed for now and the global game of risk continues.

The Saudis are not producing at full capacity by anyone’s measure. They insist their max capacity is 12.5 million b/d. Many think this is too generous. Critics say 11.9 million b/d is probably more accurate. As of today, they’re only producing 10 million b/d, which means the Saudis could still ramp up production by nearly two million b/d if we stick with the pessimistic assessment.

The Saudis are stockpiling oil in order to calm the market and prepare for the seasonal rise in demand that comes with the summer air conditioning season. But they can only flood the market if they have buyers. Since the market is already well-supplied, buyers have little reason to buy more, and so the only way to manipulate supply-demand dynamics and push down prices would be to offer discounts which make unwanted oil more appealing. There’s little reason to believe the Saudis are preparing for a fire sale, however. Discounting is tricky business because other customers may demand the same treatment.

Iran is in a very different position. They now appear to be stockpiling because they lack other options. The Islamic Republic is reportedly storing millions of barrels of oil offshore on crude tankers because they cannot find customers. Domestic storage must be nearing capacity if it is not already maxed out. Iran may ultimately sell those distressed cargoes at a discount in order to make room for future production which they are afraid to shut in.

Iran will probably flood the market with cheap cargoes before the Saudis do.

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