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The Biggest Loser Of The OPEC Deal

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Why Saudi Arabia Continues To Pump Crude At Record Levels

Hawtah field

As the Financial Times reported on 12 July, Saudi Arabia’s oil-output reached record highs in June 2016. Increasing production 280,000 barrels/day to 10.6m b/d, Saudi Arabia has once again waved off OPEC’s request not to glut the market with oil.

As it turns out, economic principles explain why the Saudis began, in late 2014, to pump crude as fast as they could – or close to as fast as possible. In fact, there is a good reason why the Saudi princes are panicked and pumping.

Let’s take a look at the simple analytics of production. The economic production rate for oil is determined by the following equation: P – V = MC, where P is the current market price of a barrel of oil, V is the present value of a barrel of reserves, and MC is the marginal recovery cost of a barrel of oil.

To understand the economics that drive the Saudis to increase their production, we must understand the forces that tend to raise the Saudis’ discount rates. To determine the present value of a barrel of reserves (V in our production equation), we must forecast the price that would be received from liquidating a barrel of reserves at some future date and then discount this price to present value. In consequence, when the discount rate is raised, the value of reserves (V) falls, the gross value of current production (P – V) rises, and increased rates of current production are justified.

When it comes to the political instability in the Middle East, the popular view is that increased tensions in the region will reduce oil production. However, economic analysis suggests that political instability and tensions (read: less certain property rights) will work to increase oil production. Related: Oil Bust Takes Its Toll On Alberta, Amount Of ‘Orphans’ Increases By 45%

Let’s suppose that the real risk-adjusted rate of discount, without any prospect of property expropriation, is 20% for the Saudis. Now, consider what happens to the discount rate if there is a 50-50 chance that a belligerent will overthrow the House of Saud within the next 10 years. In this case, in any given year, there would be a 6.7% chance of an overthrow. This risk to the Saudis would cause them to compute a new real risk-adjusted rate of discount, with the prospect of having their oil reserves expropriated. In this example, the relevant discount rate would increase to 28.6% from 20% (see the accompanying table for alternative scenarios). This increase in the discount rate will cause the present value of reserves to decrease dramatically. For example, the present value of $1 in 10 years at 20% is $0.16, while it is worth only $0.08 at 28.6%. The reduction in the present value of reserves will make increased current production more attractive because the gross value of current production (P – V) will be higher.

(Click to enlarge)

So, the Saudi princes are panicked and pumping oil today – a take the money and run strategy – because they know the oil reserves might not be theirs tomorrow. As they say, the neighborhood is unstable. In consequence, property rights are problematic. This state of affairs results in the rapid exploitation of oil reserves.

By Zerohedge.com

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  • Matthew Biddick on July 27 2016 said:
    Why don't the Saudis cut production 10%, or whatever it takes to get oil back to $100/b? Who cares if the Americans produce 9, 10, or 12 mmbopd? We are officially scaping the bottom of the barrel here with this development of shale/tight oil source rocks. This will run its course over the next 10 to 20 years and then there will be nothing left in the way of liquid hydrocarbons here. And we'll truly be in terminal decline as far as oil production is concerned.

    Then, the Saudis save those future reserves for later. They might have to cut their production in half but they'll still be making as much money as they are now at $40-$50/b. And once American production goes into terminal decline, the Saudis can raise production and still get $100, or more, per barrel. And they can hire the baddest army in the world to make sure those reserves don't get "expropriated".

    Can you work up a formula for me on this scenario? Thanks!
  • Steve on July 27 2016 said:
    The value of oil reserves does decrease due to the time value of money - fortunately, however, oil is priced in USD so is able to withstand a certain amount of Middle Eastern stability.

    A greater factor for Saudi Arabia not slowing production is due to (1) (unsuccessfully) attempting to wipe out US competition, and (2) the fact that the 14 OPEC members are largely dysfunctional and unable to work together to lower production.
  • JaytheGreat on July 27 2016 said:
    One of you questioned Why don't the Saudis cut production
    10%, to get oil back to $100/b? Who cares if the Americans
    produce 9, 10, or 12 mmbopd? Many surely care. Though
    scraping that end of the barrel might not do either nation
    so well

    I agree that in this scenario , the Saudis could save their
    reserves for the future.. But cutting the production is not as
    easy as it might seem due to competitive markets and the
    mechanism of the oil and petrol industries.

    If Saudi is now at 40-50 dollar by berral (which many assumed
    would be even lower at this point) - either way...Saudi's aim is
    not to higher the ''baddest'' army.
    Their vision for the future that was stated a few months back
    show a different path.
  • Amvet on July 28 2016 said:
    My opinion is that the Saudis increased production for three reasons, for cash flow to pay current expenses, to please the US government, and to increase the value of the stock they will put on the market.

    The market share pitch has always seemed to me to be fake. You cannot build palaces or buy Ferraris with market share. (I spent 5 years in Saudi Arabia.)

    Why should the Saudis care about market share when they could reduce production and increase profit?

    Also I doubt if the Saudis have any fear of US expensive production from fracking.
  • John Scior on July 29 2016 said:
    Interesting analysis. However, the government is pretty sound. The factors I see contributing to the increased production are 1. a lower price does negate efforts of fuel efficiency 2. alternative fuel development has slowed 3. electric vehicle production does not seem as economically viable as it once was 4. Iranian objectives of rebuilding their economy and world power are hurt by lower prices 5. When the world economy recovers more fully from lower oil prices, their is an overall increase in demand for their product.
    These factors allow the Saudi's to maintain their position on the world stage and thwart efforts to substitute something for oil thus ensuring their own long term prospects.
  • Othman Alkhowaiter on July 29 2016 said:
    Amvet said it right. You are absolutely correct. There are other reasons behind keeping production at the current level that has nothing to do with either shale oil or market share.
  • ken on July 29 2016 said:
    Another explanation is that they were told to pump more so central banks can continue their expansion of money supply through either loan/mortgage creation or QE/printing. Cheaper energy takes pressure of inflation ("no inflation here - keep moving along") so that the public can still believe that all the QE and low or no interest rates have not devalued their currencies and the charade can continue for x so many more years. The mis-information includes that the house of saud has any say and that they are doing this to take market share from frackers. Heck, fracking can and will wrap up very quickly once prices go up so this idea is non-sense. The FED and other central banks are printing and laughing. the Sauds wouldn't run 100B deficits if they had a choice.
  • Sickerforlonger on August 01 2016 said:
    There are also a number of technical reasons for the output to be sustained. Saudi Arabia and the ME as a whole has been extensively implementing infill drilling, EOR (water/gas pumping, etc) and even drilling offshore for the last fourteen years at least. This means they just can´t cut production at will, because the costs associated with increasing output again are excruciating, the process can take months and in some cases you may lose a field irreversibly. This is not like tapping anymore.

    The days of cutting production for artificially boost prices are long, long gone.
  • Tim Johnson on August 09 2016 said:
    Oil will become worth a lot less when we no longer need to burn it to power civilization.
    With dozens of peer reviewed LENR papers and over a dozen independent validations, including Top 5 engineering school Alumni, DoD qualified contractors, and Fortune 500 corporations, Brillouin LENR, and BrilliantLight Power Validation-Reports enhance investor confidence. A major announcement is only a matter of time.

    Brillouin exec Robert W. George II, said: "When we took it [our need to raise capital] to Wall Street they looked at the upside potential of this kind of technology and said its worth $Trillions. You’re only trying to raise $15-20 million. It makes no sense, we can't do that."
    Obviously the solution is to offer Wall Street a bigger deal. Ask to raise a billion dollars and they will eagerly raise the funds, since they get more for themselves. As for Wall Street funding new energy technologies, the lesson learned here is: think big or go home.

    Source: https://youtu.be/G09LRbDXGy8?t=2559

    PS: Are you listening BrilliantLight Power? Are you going to be the Microsoft of new energy, or just another CPM?

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