Oil and Saudi Arabia - Part 2
10.25.05   Ferdinand E. Banks, Professor




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 the future.”

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 consuming world.

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 diagram.

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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