Five Good Reasons Saudi Arabia Will Not "Swing" and Why $80 Is the New Normal

November 24th, 2014
in Op Ed

Written by

Now the dust from the Shock & Awe of the 30% drop in oil prices has started to settle, two things are clear: (a) Saudi Arabia did not engineer anything (b) they don't have a Machiavellian plan to stick one up the wildcatters in North Dakota, or the Russians...the Iranians...the Venezuelans, or even the genius from The Daily Telegraph who was bemoaning the fact that if oil prices go down it will be hard to import inflation into U.K.

Follow up:

Here are five good reasons why they are going to pass on the opportunity to slash their oil production by 30% so that other OPEC members can cheat and make a windfall, like they all did in 1987/8.

1. Read My Lips

Since oil prices jumped from $80 to $110 in early 2011 the Saudi's have been saying, over, and over and over again, that oil was over-priced by 20% to 40% compared to what they considered to be the "Fair Price". Here is the BREAKING NEWS...they didn't change their mind.

2. They were and still are correct about what is the Fair Price: Parasite Economics Explained

Until "Peak Oil" finally arrives (no sign of that yet), the reality is that the oil producers - particularly the Saudi's, have the ability to pump more oil than the rest of the world can (sensibly) consume. Think of the world like a cow - the oil producers are parasites living off the milk of the cow, they feed it (oil) and the cow gives them milk (money). What the Saudi's mean by the "Fair Price" is how much milk they can reasonably expect to drain out of the cow, without it suffering an attack of mastitis. Sure you can feed the cow more hay and alfalfa (oil), but after a certain point, it doesn't matter how much you feed it, you won't get any more milk, all that will happen is that the cow will get fat.

Historically, when the amount of milk (money) the oil producers pulled out of the cow, exceeded 3.3% to 3.7% of world GDP, the cow started to suffer, inflation went up and GDP stalled. When the amount of milk (money) was less than 3.3% to 3.7% of GDP, investment in infrastructure to maintain and find oil fields, suffered. What the Saudi's call "Fair Price" is the balance of those two extremes.


3. Saudi Arabia is not in an oil-war or any sort of war with Russia

How about this for war-mongering?

At a news conference after holding talks with the Saudi Foreign Minister Prince Saud al-Faisal in Moscow on Friday (21st November) Russian Foreign Minister Sergey Lavrov, said...."Saudi Arabia and Russia believe that pricing should be market-oriented and let supply and demand play the decisive role. We and our Saudi partners are against shifting markets as result of political or geopolitical schemes" (Reuters)


4. Replacement Cost

If you don't buy the cow-story, there is another way to value a finite resource that you have and make a decision about what price to sell it for. A good guide is how much it will cost someone else to find and develop oil fields. The boys in North Dakota have demonstrated that you can easily get new oil out of the ground for about $80 a barrel - and still make a profit. So that's the Fair Price, you can decide, do you sell at that price, or do you hold on and wait until that new oil is pumped, and get a better price. If you find that the other guys are selling at $100, and making a windfall, well you might just decide to make a bit of a windfall yourself. That's "fair-enough" isn't it?

5. Saudi Arabia needs to repair/refurbish their oil fields - at $80 they will buy that at half-price

It's no secret the oil-fields offshore Saudi Arabia are held together with bird-droppings. There is a real danger that at any moment there may be un-seasonal bout of rain, the droppings will get washed-off, and the whole thing will fall to pieces.

The Saudi's have been talking of spending $100 billion, perhaps $200 billion, perhaps $300 billion, to scrape off the bird-droppings and replace them with steel, put grout-bags on top of their pipelines where all the cement weight-coats are started to dissolve and so they are floating to the surface, and re-drill oil wells that were drilled thirty-years ago, using the latest technology.

But the problem was that once oil prices hit $100 four years ago, everyone went crazy and the cost of renting a drilling rig and all the other paraphernalia you need to scrape off bird-droppings and do other essential maintenance in an oil-field, went through the roof.

Fortunately the Chinese were around. You could wander-by a yard in China, put 1% down, and they would build you a brand new drilling rig. Plenty of people did that, currently there are about 550 offshore drilling rigs in the world (floaters and jack-ups), this time next year there will be 750. This time next year the price to charter one of those will be 50% or perhaps 30% of what it was last year; same story for all of the other paraphernalia. So at $80 oil the Saudi's will be able to buy the refurbishment they need, at half price.

Don't expect oil prices to go much above $90 until they are about four year's time.

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