http://www.energypulse.net/centers/article/article_display.cfm?a_id=1125
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 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.
FINAL OBSERVATIONS
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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