Why Cut Production?

In Low Gasoline Prices – Good or Bad?, I briefly discussed various conspiracy theories way back when US gasoline was $3.05/gallon. Now US auto fuels are closer to $2.00/gallon – in some areas – and international oil prices are trending lower than $60/barrel. Recently, the Minister of Petroleum and Mineral Resources, His Excellency Ali al-Naimi answered a question about Saudi Arabia controlling prices with the question, “Why should we cut production?” Many outlets are still claiming that the Saudis are trying to punish Iran, Russia, the US, or all of them.

Over the weekend I was applying Ockham’s Razor and wondered if the Saudis simply can’t afford to cut production. The Kingdom is wealthy but to stave off unrest it supports an enormous stipend system for a very extended royal family, a large bureaucracy, and generous social welfare programs for ordinary citizens. It has also forgiven enormous debts to poor neighbors like Pakistan that can’t actually pay for the oil they need to keep their economies stumbling along.

Bill McBride at Calculated Risk quotes an October post by James Hamilton of Econbrowser in support of the idea that oil prices are falling due to supply and demand:

[In October] I discussed the three main factors in the recent fall in oil prices: (1) signs of a return of Libyan production to historical levels, (2) surging production from the U.S., and (3) growing indications of weakness in the world economy.

As far as Libya is concerned, the politics on the ground remain quite unsettled. It makes sense to wait and see if anticipated production gains are really going to hold before anybody makes major adjustments.

In terms of surging U.S. production, the key question is how low the price can get before significant numbers of U.S. producers decide to pull out. If world economic growth indeed slows, and if most of the frackers are willing to keep going strong … trying to maintain the price … could be a losing bet for the Saudis. They’d be giving up their own revenue just in order to keep the money flowing into ever-growing operations in Texas and North Dakota.

And as for worries of another global economic downturn, so far they are only that– worries. If and when we see a downturn materialize, then I would expect to see the Saudis cut back production.

But until then it’s primarily a question of responding to surging output of U.S. tight oil. My guess is that Saudi Arabia would lower prices rather than cut production as long as that’s the name of the game.

But I think behind the scenes, the Saudis are also doing their part in an orchestrated transition away from the petrodollar and towards a more international basket of currencies as reserve currency.


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