Dozens of supertankers lurk motionless outside of ports around the world, filled with hundreds of thousands of barrels of crude oil. They filled up in Saudi Arabia, but instead of bringing their cargo to market, they park a few miles offshore and wait.
The tankers are owned by oil trading firms like Vitol, Trifigura, and Gunvor. Those corporations have been heavily investing in oil storage capacity since crude prices began to tumble last June. Paul Sullivan, who teaches energy economics at the National Defense University and studies future resource threats with the Federation of American Scientists, explains, “the traders are taking advantage of contango–when prices of a commodity drop and yet are expected to increase.” Today, oil is cheap. Prices have fallen by more than fifty percent over the last eight months; when prices rise, firms that are purchasing and storing crude will make huge profits.
Saudi Arabia, though, as an oil producing country, is suffering from reduced revenues and the risk of decreased global investment for new exploration and drilling. In early October 2014, Saudi Arabia’s representative to OPEC declared that the country would not cut production in response to falling prices. To understand this seemingly paradoxical move, it is necessary to examine Saudi Arabia’s past experiences in similar gluts and how low oil prices are affecting its adversaries.
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The market for oil is truly global, and changes in supply or demand in one part of the world affect prices everywhere. Current low prices developed because supply outpaced demand. At the most basic level, the global economic downturn reduced demand for oil as economic output declined. Richard Jones, former United States ambassador to Israel and Kuwait, past petroleum advisor to the U.S. Embassy in Riyadh, and the current Deputy Director of the International Energy Agency (IEA), emphasized that structural change in the global economy is responsible for the drop in demand. According to Jones, higher prices in the last few years have led to “increased efficiency in the use of oil and increased use of substitutes.”
By June 2014, the gap between supply and demand collapsed oil prices. But, the market did not equilibrate: producers did not curtail production to meet falling demand. Producers are incentivized to keep pumping, even when prices are low, because oil companies incur most of the costs of oil extraction when locating crude deposits, installing drilling equipment, and setting up their wells.
Jones articulated why producers continue to pump and oil at falling prices continues to flood the market: “Even if prices are low and the producer is losing money by pumping oil, the loss is actually going to be less than if you stop pumping, because you’ve got all that overhead that you have to pay for.”
Historically, the market has had a swing producer or bloc of producers that control enough extra supply, otherwise known as spare capacity—one that can afford to adjust production to balance the market and keep prices steady. Robert McNally, former Senior Director for International Energy on the National Security Council (NSC) explained that in the absence of an actor to control the supply, “prices tend to gyrate wildly in boom-bust fashion.”
Since the 1970s, the Organization of Petroleum Exporting Countries (OPEC) has functioned as the market manager. Saudi Arabia, OPEC’s largest producer and the holder of spare capacity, adjusted its supply to keep prices stable.McNally observed, “For most of the 1990s, it was successful at keeping prices in a narrow band.”
When Saudi Arabia does not adjust supply, price volatility returns. “From a price stability standpoint, the only thing worse than OPEC controlling the oil market is OPEC not controlling the oil market,” McNally said. The world’s bulwark of price stability abandoned the market in its time of crisis. In early October 2014, Saudi Arabia’s representative to OPEC declared that the country would not cut production in response to falling prices.
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“Oil is what Saudi Arabia has—enough to last 150-200 years from now—and it wants that to be valuable,” Jones explained. “It doesn’t want to screw things up by setting the price too high now to force the world onto alternatives.”
The Saudis are looking beyond the temporary pressure on their budget, which is largely dependent on oil revenue, and considering their long-term objectives. The Saudi decision to cut production must balance immediate revenue considerations with the risk that their customers will switch to other producers or invest in alternate sources of oil and energy.
Saudi Arabia’s political structure protects itself from large doctrinal shifts when rulers change. The king, the crown prince, and the deputy crown prince have “all been involved in debating the policy,” said Jones. Saudi Arabia demonstrated its consistency on January 23 when King Abdullah died. Crown Prince Salman ascended the throne and declared he would keep oil production constant. Jones says this is unsurprising, as Salman was intimately involved in all discussions about oil policy as crown prince.
Salman doesn’t have to rely on guesswork to set policy; the inner circle of the Saudi monarchy remembers the effects of their decision to cut production in a similar glut in the mid-1980s, and was likely trying to avoid repeating the incident. According to Michael Oppenheimer, professor of international affairs at Princeton University, after the Iran crisis caused spikes in prices in the late 1970s, crude prices collapsed in the early 1980s in response to producer competition and falling demand. To adjust to the high prices of the 1970s, “The US passed fuel economy standards for motor vehicles,” Oppenheimer recalled. “They started to bite in 1980, and because of that, greater fuel economy did reduce demand.” Facing lower worldwide prices in the 1980s, OPEC sprung into action, and called upon Saudi Arabia to curtail production. Riyadh did, and prices rose.
But those higher prices effectively encouraged competing producers to increase investment in exploration and expand output, and they ultimately undercut Saudi market share. Keith Crane, director of the Environment, Energy and Economic Development Program at the RAND Corporation, explained, “All the oil producers benefited [from those higher prices] except Saudi Arabia.” The decline in output put substantial financial stress on the kingdom. Jones, who was in the U.S. embassy in Riyadh in the summer of 1985, told The Politic, “Revenues were falling much faster than they could ever tighten spending. We estimated that at current trends, Saudi Arabia would be broke within a year.” Something had to give.
In deciding to maintain production levels today, Saudis planned for the future. By doing so, Saudi Arabia can drive higher-cost producers out of the market and watch supply decline and prices rise while still maintaining its high market share.
“Saudi Arabia looks at the US oil boom and says—actually, it’s been a great thing,” McNally observed. “They love shale because it’s flexible. Unlike most oil, where it takes a long time to increase supply, shale oil comes on really fast with a lot of oil up front. The Saudis appreciated U.S. shale’s help in putting a $115 ceiling on prices in recent years. Now that supply and demand are weakening a bit, they are insisting the U.S. build the floor—they swung up, now they can swing down.”
Furthermore, if Saudi Arabia reduced production, the producers with the most potential for growth—Iraq and Iran, led by largely-Shiite and all-Shiite governments respectfully, and Russia, which supports the Assad regime in Syria—are Saudi Arabia’s greatest geostrategic threats. McNally concluded, “Saudi Arabia doesn’t want to cut their production just to support Iraq’s production growth, and eventually Iran’s and Russia’s.”
Most actors in the global market did not anticipate Riyadh’s decision. It has been almost one hundred years since the boom-bust cycles of the 1920s that occurred in the absence of an OPEC-like organization. “It’s hard to overstate what a shock it was to market participants” that the Saudis kept up production levels, McNally remarked.
The global and strategic effects of falling oil prices can be near revolutionary. In the late-1980s, Saudi Arabia crushed prices by ramping up production, and, in doing so, crushed the former Soviet Union. The question now is not whether the current prices will change the global landscape, but rather how impactful and long-lasting the changes will be. The countries that rely heavily on oil revenues to keep their budgets intact will be most affected. Russia and Iran have almost no reserves, putting them in particular in danger.
Russia finances about 65 percent of its annual budget with oil revenues. Economic sanctions imposed on Russia by the U.S. and the European Union since March 2014, in response to Russia’s invasion of Ukraine, have depleted Moscow’s cash reserves. “When the oil prices go down, then Russian export revenues are hit hard,” Professor Paul Sullivan, who teaches energy economics at the National Defense University, maintained. “Add this to the sanctions, and the Russian economy might drop five percent in 2015.”
While economic pressure theoretically should restrict Vladimir Putin, any change in his actions is unlikely. “He recently increased Russian defense expenditures. He is [not being realistic] about Russia’s economic and political situation that makes him and Russia all the more dangerous,” Sullivan argued.
Even if the prices do not alter or deter Putin’s geopolitical goals, they will at least stunt his ability to achieve them. “Russia has less money,” Jones observed, “which means it has less revenue from the government to spend on supporting separatists in Ukraine.” More importantly to Saudi Arabia, Russia will also be less capable of supporting the al-Assad regime in Syria. At least in the short term, low prices contain the extent of Russian damage on international stability.
Iran will similarly struggle. The International Monetary Fund estimated that for Iran to stay fiscally solvent, oil prices need to hover around $130 to $140 a barrel—about three times current prices. However, unlike in Russia, where Putin has a firm hold on internal politics, low prices have the potential to affect the internal dynamics of the Iranian regime.
After the most recent presidential election in 2013, reform factions within the government gained momentum in their efforts to implement economic and foreign policy reforms. Crane explained, “The institutions that support the Supreme Leader [Ali Khamenei]—the theocratic elements of the government—rely on oil money for what they do. This whole apparatus got a lot less money, and so there are a lot of things changing in internally.” This structural instability may be the impetus for lasting reforms in internal policy, as conservative forces weaken. This is good news for Riyadh, as the conservative factions in Iran most strongly promote the Shiite ideology that Saudis oppose. Sullivan, though, conceded that low prices have not “slowed down Iran’s activities in Lebanon, Syria, Iraq, Yemen, Eastern Saudi Arabia” in the short term, or Iran’s support of other Shiite groups. While oil prices have potentially large consequences for the internal balance of power in Iranian politics, they likely will have less of an effect on Tehran’s foreign policy strategy.
Ultimately, however, the lasting implications of low oil prices are unclear. “The price will [eventually] go up,” Sullivan contended. The question is by how much, and when. Jones capped the maximum prices for oil in the foreseeable future at around 70 dollars a barrel, higher than current levels but still far below the amount needed for long-term solvency in countries reliant on oil revenues. Riyadh is “weathering the crisis” by relying on its foreign currency reserve and low-enough production costs to offset falling prices, says Professor Tulia Falleti, political scientist at the University of Pennsylvania. For now, Saudi Arabia can sit back, hope its enemies flounder, and plan for the future.