The Real Reason Why Saudi Arabia is Dropping Oil Prices?

The Real Reason Why Saudi Arabia is Dropping Oil Prices?

In Feb 2016 the Crude oil price hit a record 12 year low of 26$. Many people are in the misconception that this is because Saudi Arabia is pumping a lot of oil and the reason why they are doing so is to kill the North America Shale or are being pushed by US as it want to run Russian companies into bankruptcy or Saudi wants to do the same thing with IranToday, at Zuleb, we are going to show you how both these notions are wrong and how the above is a result of incorrect analysis.

The real reason why Saudi is Pumping oil is very simple. They can not control the oil prices by themselves. It should be understood that Saudi controls only 13% of Oil Production in the World, definitely high but not high enough.

Saudi Oil Production Percentage
Image: Econographics

The only way Saudi Arabia can increase prices is if they cut production. The problem is if Saudi decides to cut production, the prices will rise, but not very much. This means, they prices may increase about 10-15% but since you just plunged the volume, you also lost a huge amount of money. It makes zero financial sense for Saudi Arabia to take that step. They do nothing but lose money in this scenario.

So, it’s clear that Saudi Arabia can’t do anything by itself. The next thing will be to look at OPEC. The 14 countries who jointly control 40% of oil production. Which, is very less than what they used to control before, which was over 50%. If OPEC as a group jointly slashes production it will make a huge impact, obviously. But, the problem is they won’t. Because they all have a huge trust issue. An organization only survives if all the members trust each other not to cheat. If a country continues to pump oil in greed of taking maximum benefit of the drop in oil prices the plan fails. The bottom line is Saudi Arabia absolutely doesn’t trust OPEC. And it has a very good reason to do so.

Image: Dallas News - OPEC
Image: Dallas News – OPEC

To understand this, you have to travel back in time. Back in 1980’s Saudi Arabia arranged a meeting with all the heads of OPEC to discuss in the sudden drop in  prices. Based on the meeting a conclusion was reached that all the countries will drop the production. Saudi did exactly that, they dropped the production to a record low. The rest of OPEC didn’t stick to it and continued to pump. The Saudis went forward, undeterred. The slashed their production to a mere quarter of previous levels but nothing happened.

Drop in Oil Production by Saudi
Drop in Oil Production by Saudi

The rest of OPEC didn’t bother, and prices, obviously, didn’t rise by that much (certainly not enough to make up for a 75% fall in volume). Saudi Arabia lost a shit ton of money and got super pissed. They turned the oil tap back on and flooded the market, and prices dropped like a brick causing the famous or infamous oil glut of 1980’s. That moment basically sealed the end of OPEC.

A similar situation came in the 91 Gulf war. Saddam wanted to cut production so that the prices will rise and he and other members can benefit from it. But, Iran hated Saddam, and Saudis didn’t trust him (or anyone else for that matter), so nothing happened. The entire OPEC did manage to agree on a term in 1998 when the prices had gone to a record low of 15$ a barrel. This production cut was very mild. This wouldn’t have worked for that long, nor would have affected OPEC. But few geographic factors managed to save them.

As we entered the 21st century three main things happened which had a huge impact on oil.

  1. 9/11
  2. Two wars in the Middle East
  3. High increase in oil demand for China and India

Because of the above events, the price of the oil inflated into the sky without any need of oil slash. It marked a stage of Nirvana for oil companies. This lasted for almost a decade and in 2008 when the recession hit the prices plunged again. The logical thing was for OPEC to come together and work on dropping the production. But, it didn’t happen like that because of a continued mistrust which remained because of their history. As reported in this NY times article “On 10 September 2008, one such production dispute occurred when the Saudis reportedly walked out of OPEC negotiating session where the organization voted to reduce production. Although Saudi Arabian OPEC delegates officially endorsed the new quotas, they stated anonymously that they would not observe them. The New York Times quoted one such anonymous OPEC delegate as saying “Saudi Arabia will meet the market’s demand. We will see what the market requires and we will not leave a customer without oil. The policy has not changed.”

This, basically was the new policy of OPEC. Agree to cut, play Judas, continue production. Saudi’s basic policy has been to pump their ass out. The reason is pure financial. They don’t trust the OPEC members, definitely not countries like Venezuela who are for sure going to cheat. There may be some trust among Gulf countries but not with members at large. Too many countries with poor governments and deceitful leaders. Take a note, that this way before shale became close to be a major player.

So, now today we see a decrease in oil cost because of two big reasons. Increase in oil production because of Shale in North America and decrease in demand in China. There are many demands to cut the oil prices but Saudi oil Minister has openly declared that they won’t. For OPEC to come together things have to get extremely bad, as they did in 1998. To put it simply, Saudi Arabia can still make a chunk load of money by pushing oil at the current rate. The above factors are just side effects. The Saudi will love to see if they can run Shale out of production, and will love to see Iran feeling the burn. They probably are also very much happy to see Russia hurt, as they are the one financing Assad in Syria. All these is true but it’s just a side effect.