Burning The Midnight Oil

Burning The Midnight Oil

“You can’t run a business based on sympathies,” the controversial billionaire oil broker, Marc Rich once said. The business of oil is no different; it lubricates the region. And as the price of oil has taken a hit from a high last year of $115 a barrel to $50 a barrel, many are casting about for reasons as to why. In recent weeks, Saudi Arabia has attracted much criticism from analysts over its response to tumbling oil prices. As the nation met with other oil suppliers on December 4 in Vienna, it let it be known that that it wouldn’t reduce supplies to stabilize the price.

Some are ridiculing the Kingdom for undertaking what they regard as a failed gamble to knock shale oil producers out of the market or to exert economic pressure on Russia. But a closer examination suggests that Saudi Arabia’s official reasoning—the defense of market share—is on point, and is also the right thing to do. Saudi Arabia has its interests as well as those of the global economy to consider, after all.

Few can forget the first oil shock of 1973 that many associate with the Organization of Petroleum Exporting Countries (OPEC). Indeed, there are many misconceptions about OPEC. Some often perceive it as an omnipotent monolith that holds the global economy at its mercy, raising or lowering prices on a whim. The inaccuracy of this characterization is evident when one asks the following question: If OPEC can easily raise oil prices, why wait for prices to fall so steeply to intervene? Why not always keep prices at $150 a barrel?

But this is to misconceive of what OPEC does, or what it stands for. OPEC does not keep prices high for the same reason that Safeway, Toyota, and your local hairdresser refrain from charging exorbitant prices: Market competition prevents them from doing so. OPEC accounts for approximately 40 percent of international oil production and has to compete with non-members such as Canada and Russia.

Controlling a minority stake in the market is not terminal to the hopes of a prospective cartel if in the first instance, all of its competitors are producing at capacity, and if secondly, that capacity is fixed. Whether or not that used to be the case, it is not the case at present, due to shale oil. Despite being more expensive to extract than Saudi Arabian oil, setting up new shale oil wells is a swift and inexpensive process, meaning the industry is highly responsive to increased prices. The sharp spikes of yesteryear are now but a distant memory.

Further, conflicts between OPEC members pose a greater hurdle. Operating a cartel is challenging because of the difficulty of ensuring compliance. Since the 1980s, OPEC countries’ oil production exceeds their quotas 96 percent of the time, says Brown University’s Assistant Professor of Political Science and International and Public Affairs, Jeff Colgan. In fact, production levels and quotas are uncorrelated. After controlling for the political, technical, and economic factors that affect oil production decisions, the output of OPEC members is indistinguishable from that of non-OPEC members.

Simply put, OPEC members have not been coordinating. Why is this the case? Ensuring compliance is hard enough when the cheats are motivated by profits. In the case of OPEC, there are larger, geo-strategic conflicts among the members, rendering a unified OPEC policy even less likely. For instance, in the event that Saudi Arabia committed to cutting output, what mechanism could ensure that Iraq and Iran follow suit? The central Iraqi government is unable to control even its own production, with Iraqi Kurds operating virtually independently. So what hope does Saudi Arabia have of convincing its geo-strategic rivals to adhere to a nominal quota that nobody has any history of adhering to anyway?

All of this leaves us looking at an oil market that is nearly competitive, confirming the acumen of Saudi Arabia’s decision to protect its market share. The Kingdom has not, however, been “flooding the market.” Saudi Arabian production since 2012 has been steady. The recent increase in global oil production is due to U.S. shale oil, and Iraqi and Libyan oil resuming production after recent disruptions. In fact, during the last 20 years, Saudi Arabia’s preference for stability in all spheres, as well as its desire to assist its key ally, the United States, has led it to use its spare capacity to compensate during supply disruptions from other large producers.

Saudi Arabia’s geo-strategic and oil-market competitors would love to see the Kingdom cut its own production, as they would try to seize market share to benefit from the economic losses that Saudi Arabia would incur. Maintaining production is the right call for Saudi Arabia. More importantly, low oil prices assist the global economy’s fragile recovery. The move should be welcomed.

Omar Al Ubaydli is the program director for International and Geo-Political Studies at the Bahrain Center for Strategic, International and Energy Studies, an affiliated associate professor of economics at George Mason University, and an affiliated senior research fellow at the Mercatus Center.

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