SAUDI ARABIA AND OIL
Just before I began to study energy economics, which was around
the time of the first oil price ’shock’, the Saudi Arabian oil
economy was being programmed by its foreign ’owners’ (which
included Exxon, Texaco, Standard Oil of California, and Mobil) to
produce 20 Mb/d of oil. Exactly how that figure was reached is
unknown to myself, however given the extremely low cost of
producing oil in Saudi Arabia at the time, certain academic
economists had no difficulty accepting that in the light of the
existing and the expected price, 20 Mb/d was an appropriate profit
maximizing quantity for the government of that country.
But despite the unsolicited scholarly expertise at his
disposal, as pointed out in the staff report mentioned in the
first paragraph, Crown Prince Fahd stated that ”Saudi Arabia has
worked and is working sincerely and earnestly to provide an
appropriate level of oil and gas production as an expression of
its feeling of shared responsibility in the international
community, but our feelings of responsibility toward future
generations in Saudi Arabia also claim careful consideration and
the establishment of a calculated balance between the present and
This kind of thinking is not commensurate with an output of 20
Mb/d. The more oil used today, the less will be available
tomorrow; and thus the monetary return from the present output
should take into consideration the amount of profits and/or
consumer satisfaction that might have to be sacrificed later. Put
another way, the cost that we should be dealing with at each
moment of time should include a scarcity rent or scarcity royalty
that is related to the using up of a depletable (or exhaustible)
resource. This is not an easy thing to calculate, although it
might be suggested that the scarcity royalty on Saudi Arabian oil
is considerably larger than that of the oil in Denmark, largely
for macroeconomic reasons that cannot be gone into here.
In any event, the proposed production – and specifically the
plateau rate – of 20 Mb/d mentioned above was soon scaled down to
16 Mb/d, and from there to 12, and subsequently to less than 10.
At the same time it appears that investments were undertaken to
provide for a surge capacity of about 10.5 Mb/d. (Surge capacity
represents the output that can be provided for a short period of
time – perhaps several weeks or longer – without damaging the
reservoir.) A great deal is now being made of that capacity –
which today might be as high as 12Mb/d – because theoretically it
represents a particularly valuable piece of insurance for the oil
In addition, Crown Prince Fahd informed the large oil importing
countries that their best strategy was to moderate their
consumption of oil, while introducing as rapidly as possible
alternative sources of energy. Since he also emphasized the need
to preserve his country’s petroleum wealth for future generations,
it seems likely that, unlike certain prominent academics, he did
not view the oil reserves of his country as inexhaustible.
Now let’s go back to the figure given above as the possible or
desired production of Saudi Arabia in 2030 – i.e. 20 Mb/d.
Amazingly enough, in the early l970s, the Arabian American Oil
Company (Aramco) – which was jointly owned by the Saudi government
(60%), and four American oil companies (Exxon, Texaco, Standard
Oil of California, and Mobil) – intended to establish by the early
l980s a maximum output potential of 20 mb/d.
Fortunately for all of us (i.e. both producers and consumers)
this economically insane program was cancelled after the
nationalizations that took place as a result of the l973 war in
the Middle East. The main reason given by the new owners – the
Saudi Arabian government – was that an output of 20 Mb/d entailed
mismanaging a national asset. Every person of normal intelligence
who is responsible for managing the economic future of themselves
or their family should intuitively agree with this, even if they
are oblivious of some of the technical details that play an
important role in programming the flow from petroleum reservoirs.
The crucial observation in this case is that an output of 20 Mb/d
could only be maintained for a relatively short period of time
without badly damaging reservoirs and reducing future output. In
addition, after ramping production up to 20 Mb/d, the billions of
dollars spent for fixed investment to produce and distribute that
amount of oil could be lost due to the inevitable decline in
output (and, once again, if this decline were delayed, then when
it took place it would be steeper).
Some citizens of Middle East countries – to include Saudi
Arabia – were quite vocal about the economic and social
inadvisability of producing too much oil. According to an article
in The Economist, (May 29, 2004), Mr bin Laden was one of them,
but when I gave my recent lectures on energy economics I limited
myself to referring to the last Shah of Iran, who often stated
that petroleum was too valuable to be “burned up in the air”. When
I used that expression at the international meeting of the
International Association of Energy Economics (IAEE) in
Copenhagen, in 1991, it caused some annoyance, but I can’t really
understand why, since as I later found out many persons from that
part of the world were thinking along the same line.
The Middle East has an enormous competitive advantage in
petrochemicals, and perhaps also in refining. Moreover,
remembering my talk in Copenhagen, I have some difficulty
understanding why half of the new capacity that is planned for the
coming decade, is not already on line. According to the Financial
Times (September 21, 2005), one of the problems facing Saudi
Arabia is that it is not a member of the World Trade Organisation,
which means that it is “fair game for protectionist measures”.
Personally, I have a difficult time imagining any government
initiating protectionist measures against the global oil
superpower, particularly since that superpower is ostensibly
“looking at scenarios to bolster production to even 15 Mb/d”
(Business Week, October 10, 2005). Preparing various lectures has
interfered with my study of game theory, but what they are
probably looking at are scenarios that would help them to convince
the rest of the world that they can or will produce 15 Mb/d, and
in addition produce this amount over a long period. The first
‘might’ happen, but the last is completely out of the question,
and should be recognized as such.
I can add that if a country like South Korea could build a
viable petrochemical export industry although it lacks domestic
petrochemical feedstocks, or inexpensive energy for running these
facilities, then a country like Saudi Arabia has an indisputable
edge over any and all competitors.
Before concluding this part of the discussion, I would like to
cite the opinion of the Houston investment banker, Matthew R.
Simmons, who has attracted a great deal of attention with his book
‘Twilight in the Desert’ , in which he says that Saudi production
may be peaking. Peaking in this case probably means that while it
will not increase, it may not decline by a palpable amount in the
near future. Simmons undoubtedly is a strong believer in this
prospect, because he had bet a New York journalist and the widow
of economics professor Julian Simon $5000 that the price of oil is
on its way to $200/b. I predict that Mr Simmons is certain to lose
that bet, because assuming that the oil price continues to rise at
the rate experienced over the past 3 years, then long before it
reaches $200/b we will have to deal with a new world depression –
observe, depression and not recession – and perhaps the run-up to
the Third World War, or even the real thing.
One of the reasons that I enjoy citing the US document
mentioned in the first paragraph of this paper, is that one of the
gentlemen on the Senate Committee on Foreign Relations who,
presumably, joined in the ordering of that report, was a teacher
of mine at Illinois Institute of Technology (in Chicago) in my
freshman year. More important, Professor S.I. Hayakawa was one of
the few teachers who did not give me a failing grade for his
course – although since I was expelled from that university for
poor scholarship soon after, he did not have the opportunity to
repeat that charity.
Unfortunately I do not know why this brilliant man decided to
leave academia and enter politics, but when I returned to IIT
after a wonderful vacation in the United States Army, he had
departed for what he apparently thought was a bluer horizon – one
that was, in those days, visible from California. One thing
however seems likely: if he had read that document, he would have
understood its significance, because although he was a teacher of
English, and not engineering, he was capable of realizing that the
Saudis would figure out, or already knew, that there was no
political or economic reason to produce the 20 Mb/d that certain
people thought were reasonable, nor for that matter the 15 Mb/d
that we hear so much about at the present time.
As I found out the other day in a seminar here at Uppsala
University that treated the market for electricity, even
professors of economics at Cambridge University can display an
almost ludicrous inability to comprehend how real markets work –
as compared to those fictitious contrivances in their mostly
unread publications. Amazingly enough, this sometimes applies to
persons writing about finance, and perhaps even working in that
very competitive field.
Of course, a large part of the gross lack of comprehension in
matters dealing with oil and electricity (deregulation) has to do
with the healthy financial rewards that are available for NOT
understanding, or at least pretending not to do so. It is now
widely claimed that things like ‘hedge funds’ are responsible for
the great volatility of oil prices, but in truth the key issue is
still supply and demand, along with the fact that the presence of
large inventories means that we might be dealing with an analogy
of what electrical engineers call a first-order servomechanism.
“might be”, because the order could be higher.
We can now look at some basic analytics of short run pricing,
but on an elementary level. As it happens, the exposition includes
the diagram that is shown just below in Figure 1. This can be
skipped by readers who are not comfortable with this approach, but
I can mention that first year students in my finance classes who
could not reproduce and discuss this diagram in the final
examination were assured of a failing grade.
Oil inventories (i.e. stocks) are a stock concept: they are
defined in e.g. barrels, and measured at a certain point in time,
but they lack a time dimension. In Figure 1 they are designated by
AI and DI. On the other hand, production (s) and demand (h) are
flow concepts: they are defined and measured in terms of a certain
unit of time (e.g. Mb/d).
Stocks and flows are closely related, since the change in
stocks is determined by the net investment in stocks during a
given period, or s – h (supply minus demand). Moreover, we define
equilibrium in the stock market as the situation where desired
stocks (DI) are equal to actual stocks (DI = AI). If the stock
market is out of equilibrium, e.g. DI > AI, then in the flow
market we must have s > h in order to fill this gap. With this the
case, price can be expected to increase, and the amount of the
increase says something about how rapidly inventory holders want
additional inventories. We should thus feel comfortable writing
the price change (per period) as ?p = v(DI – AI). What we have
here is a simple linear relationship between excess stock demand
and the change in price, where v is a constant. Now let us look at
The current (or flow) supply (s) goes into stocks (i.e.
inventories) and current (i.e. flow) demand (h). Price is formed
by the relationship of actual stocks (AI) to desired stocks (DI),
with the flow equilibrium [s(p) = h(p)] playing a secondary (but
important) role. The equilibrium expression is AI = DI, and when
this situation prevails, s = h, and price is constant. Put another
way, a stock equilibrium implies a flow equilibrium, while a flow
equilibrium does not imply a stock equilibrium. In this type of
model expectations are very important because of their influence
on desired stocks, and in the real world expected prices are
undoubtedly more difficult to describe than via the simple
expression shown in the figure: pe = f(p). Let me also mention
that in my textbook I include a more conventional analysis,
employing stock and flow supply and demand curves of the kind
developed by Bushaw and Clower (1957). These two authors also
present a comprehensive mathematical treatment of the kind of
dynamic problems that are explicit in stock flow models, and which
make it clear that we could be dealing with a market that is
inherently very volatile.
From the above discussion we can immediately derive a simple
expression for the movement in prices. With ‘v’ a constant, we
might have Dp = v(DI – AI): when desired inventories are greater
than actual inventories, price increases. (See also Allen (1960)
for a number of ways to formulate this approach.) We can now ask
how we reach equilibrium, and the answer is uncomplicated. If the
flow demand and supply curves are of the usual types – i.e. have
the usual slopes – then the increase in price raises flow supply
above flow demand, resulting in an increase in inventories that
continues until AI = DI, and Dp =0.
One final observation. There is a theory making the rounds that
a serious act of terrorism could play havoc with the supply of oil
from Saudi Arabia. This is true, although simple arithmetic leads
me to believe that a really drastic act of terrorism in that
country is unlikely, even if it is possible. Protecting the oil
facilities of Saudi Arabia is definitely within the competence of
the Saudi government, and besides, the escalation in oil prices
has provided the government of that country with economic and
social options that were unthinkable when the sensation-mongering
media of the rest of the world were comparing the price of a
barrel of oil with a barrel of coca-cola.
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