Saudi’s oil market strategy makes sense

In December Saudi Arabia’s oil minister Ali al-Naimi posed an interesting question: “Is there a black swan out there that we don’t know about which will come by 2050 and we will have no demand?”

Obviously, we do not know the answer. However, it is almost certain that prospects for a big innovation that validates his anxiety have been increased by very high oil prices. This suggests that Saudi Arabia did itself no favours in the past by cutting production to support such prices.

Mr Naimi implicitly recognised this point in a speech he gave to the German-Arab Friendship Association in Berlin earlier this month. In the talk, he pointedly referred to the effect of high prices on development of high-cost reserves:

“When prices are rising, or at a historic high, as they have been over the past few years, the global oil industry tends to increase investment. So we have seen higher production from oilfields that are more costly to develop or operate, such as in the arctic, deep offshore, heavy oils in Canada and Venezuela, and shale oil deposits in the US,” he said.

Mr Naimi then added tellingly: “It is not the role of Saudi Arabia, or certain other Opec nations, to subsidise higher cost producers by ceding market share.”

While leaving the door open for an agreement between Opec and non-Opec nations to stabilise prices, Mr Naimi made it clear that Saudi Arabia, as the world’s low-cost producer, would not make sacrifices for other high-cost producers. He also implied that Saudi Arabia did not intend to make it easier for alternative energy sources or conservation efforts to replace oil.

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Mr Naimi has raised an important and relevant point. Changes in the technology of production and consumption and the availability of alternative fuels threaten to alter energy markets permanently. Further changes could result in nations agreeing to limit greenhouse gas emissions, or worse, individual jurisdictions such as California embarking on radical programmes to end hydrocarbon use. The prospect of global economic growth falling short of the rates recorded before the Great Recession is an additional threat.

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In this context it is a rational strategy for the kingdom to refuse to cut production. In effect, after raising the spectre of black swans, the Saudis are taking steps to increase the likelihood of oil continuing as an important source of world energy in 2050. By maintaining production and allowing prices to fall, Saudi Arabia and its allies in effect are starving the black cygnets to death.

The implications for those engaged in oil exploration and production, as well as those developing alternatives such as electric cars or renewable fuels, are obvious. Oil prices will be much lower than anticipated. The lower prices will force those who back alternatives to look for larger subsidies or make a greater effort to reduce their costs.

The Commodities Note is online commentary on the industry from the Financial Times

Philip K Verleger Jr retired from the University of Calgary where he was the David Mitchell-EnCana Professor and now heads PKVerleger LLC; he was director of the Office of Energy Policy at the US Treasury in the Carter administration.