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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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!
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.
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.
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.
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.
The days of cutting production for artificially boost prices are long, long gone.
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