The Oil Drum

Many believe that oil pricing is arrived at by a free market process, where demand and supply from buyers and sellers of equal pricing power meets, to arrive at a balanced price. This is clearly not the case.

Production and - more crucially - export supply, comes from a handful of national oil companies in countries where oil export income comprises the largest part of GDP. They are almost all authoritarian (some populist, some hereditary) dictatorships whose leaders remain in power by the distribution of oil munificence in exchange for popular acceptance - if not always genuine support. Continued survival is the primary concern of such regimes and their practices are not always informed by the pure commercial logic of free markets.

This oil export oligopoly cannot even properly be termed a commercial cartel, because its members' agendas frequently include major political and social objectives far removed from the consistent control of supply and demand. Complicating this arrangement is the fact that only one member (Saudi Arabia) possesses true swing export production capability and large reserves, combined with the financial wherewithal to use them for extra-commercial reasons; its oil export revenue under "normal" pricing conditions far exceeds its domestic fiscal needs. Other major exporters need the money to sustain large, mostly poor populations: Russia, Iran, Iraq, Mexico, Nigeria, Venezuela, Azerbaijan, Kazakhstan, Libya, Algeria and others are in that category. Those producers are ultimately relegated to following the pricing lead of Saudi Arabia.

There was a period in the 1980's-90's when high production from non-cartel nations like the UK, Norway and the US's Prudhoe Bay combined with energy conservation temporarily reduced the cartel's power but it ended quickly, along with western oil reserves. However, this period of low prices and plunging revenue left very lasting impressions on Saudi Arabia and Russia. The first one came very close to national bankruptcy and the second one imploded from a world empire (USSR) to a second-rate has been (at the time). There is no question whatsoever that the price increases in 1999-01 were at least partly engineered in co-operation with the G-7 consuming nations to salvage the Saudi regime and to avoid Russia's slipping into chaos while still possessing nuclear weapons (see "The Shocks of a World of Cheap Oil" in Foreign Affairs, Jan/Feb 2000). The subsequent rise of China as the manufacturing center of the globe brought demand nearer to production capacity and strengthened Saudi Arabia's pricing power.

Today, the Kingdom of Saudi Arabia is the undisputed oil pricing "king". It could, if it wanted to, remove significant amounts of oil from the market and still maintain roughly the same level of revenue through higher prices for some time. But that would be against its longer term interests, which include political survival of the House of Saud for as long as possible.

This brings us to a seemingly counter-intuitive conclusion about oil prices and KSA's role: it does not want oil prices to become so excessive as to permanently destroy demand and thus have to cut production even as prices drop. Such an event would drastically reduce oil revenue available for domestic spending and threaten the Saud's hold on the throne. Other export nations do not face the benefit of this "royal dilemma" and are mostly forced to pump nearly at maximum, at all price points.

Is there a bottom line to this, relevant to recent price action?

Emphatically, yes. Despite apparently continuing high global consumption (as shown in steady production volumes)prices have dropped 30% from the high in a very suggestive "waterfall" pattern. Part of it can be ascribed to speculative de-frothing, itself somewhat brought about by Goldman Sach's timely Commodity Index re-balancing and general profit-taking. But the rest must be traced back to the one exporter that can make all the difference when it comes to physical oil supply and does not want consumers to permanently switch their energy sources to PHV's, PV's and the like: Saudi Arabia.

Like the elephant in the refrigerator, it may not be seen by those of us who just happen to open the door now and then, but its footprints are certainly all over the butter.

Regards