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Opinion: Saudis continue to play long game as oil price pain endures

Saudi Arabia's Port of Jeddah has been closed following an explosion on a product tanker, possibly linked to the Yemeni conflict.
The Saudi Arabian city of Jeddah

The world crude oil price has been fluctuating around a low-level of $50/barrel for three months, now the prospect seems even gloomier as the International Energy Agency projects that 41% of the world market will continue to be taken by OPEC countries until 2020, with the rest of the world stagnating their production.

While OPEC countries have played an important role in the world oil market, a closer look at the historical data reveals that Saudi Arabia is the biggest player.

Not only does Saudi Arabia have the largest market share among the OPEC countries historically, it also has enjoyed the highest spare capacity.

In other words, Saudi Arabia is in a better position strategically compared to other oil producers, both OPEC and non-OPEC, due to its unique ability to respond to the changing condition fast.

Historically, Saudi Arabia also shows the highest volatility in terms of its market share.

Recent research I undertook with her my co-authors in Dallas Texas on Saudi Arabia and the world oil production, shows that its behaviour is consistent with profit-maximisation of a dominant producer.

With the current relatively weak world demand for oil, if Saudi Arabia considers the short-run production cut required to reach a higher price is too large, it would perceive the option of lowering production as resulting in net profit reduction.

It would still be optimal for Saudi Arabia to maintain the current production, even though this would mean its profit for now is lower than pre-2014 level.

Furthermore, maintaining the production would also mean that some of the higher-cost oil producers will be forced out of the market by the current low price, which will gradually bring the oil price back up.

Saudi Arabia seems to prefer this scenario for the maximisation of its own profit. After all, it has seen worse in the 80s, as today’s oil price in real term is still higher in 1986, and for most of the 1990s.

The research also shows the recent price drop can be mainly explained by an unexpected supply boom. Investment in earlier years resulted in 13% increase of Russian production from 2004 to 2014, with 1.01 million barrels-per-day produced in 2014 (Russia overtook Saudi Arabia and became the largest producer of crude oil including lease condensate in 2006).

Since 2008, the US shale revolution reversed the earlier consecutive production decreases and saw a 72% increase, with 8.6 million barrels-per-day produced last year. How long the supply adjustment will take under the current low price is still uncertain. While drilling activities in US have decreased for several months, certain regions still continue to see production increase.

While the current market shares of Russia and the US are comparable to Saudi Arabia, how long it takes for their higher-cost production to decrease to a level that brings up the oil price is not clear.

More importantly, the lower investment activities today in some regions will affect their production in the medium-run.

How soon the lower investment activities will result in fewer production and how long the current higher-cost production will decrease are the key to the cycle of price recovery. These two key measures could well be different for traditional and shale oil production, and across different regions.

The US Energy Information Administration projects the adverse effect on production will take more than five years to finally appear in non-OPEC countries, but there’s still considerable degree of uncertainty.

Xin Jin is Lecturer at the University of Aberdeen and has a Ph.D in Economics. Her main areas of research are energy economics, applied econometrics, macroeconomics and monetary economics.

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