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Geopolitical Diary: The Saudi’s Oil Game Plan

The long-awaited Jeddah Oil Conference on oil supplies was held and yielded the long-expected answer. The Saudis are going to increase oil supplies by the amount floated a week ago, and are prepared to increase supplies even more if there is demand for more product, which they do not see at this time. The subtext of the meeting was simple. Oil prices are not the result of insufficient supply or extraordinary demand. Supply and demand are pretty much balanced. Therefore, $135 a barrel for oil does not represent a problem to be solved; it represents a reasonable price for crude.

It doesn’t take a rocket scientist to understand the Saudi view. Making a $135 a barrel is better than making a $100 a barrel, and beats the hell out of making $50 dollars a barrel. In some cases, countries that buy oil might have non-economic leverage to use against oil producers. In the case of Saudi Arabia, the most important exporter, there is not much that can be done. On the contrary, the Saudis have the leverage.

The only country that could use political leverage against the Saudis is the United States, and at the moment the United States is more dependent on the Saudis politically than the other way around. The Saudis are critical to two major strategic U.S. initiatives: stabilizing Iraq and the Israeli-Palestinian talks. The Saudis are not involved in these matters for Washington’s benefit, but Washington is benefiting. There are no non-economic threats the United States could make, assuming it would really want to bring down oil prices.

The fact is that the United States is benefiting geopolitically from higher oil prices. Certainly it is putting significant pressure on the U.S. economy, but nothing compared to the pressure being placed on China. The United States figures that while it can get cheap goods from China and elsewhere in the world, the weakening of China’s global position certainly does not cause the United States much grief. And the role the Saudis are playing in stabilizing the Middle East is also to the United States’ benefit. Relieving geopolitical pain in return for increasing economic pain sometimes makes sense. But the truth is that it really doesn’t matter what Washington thinks about higher oil prices. They are a reality, so Washington might as well get the benefits.

From Saudi Arabia’s point of view, there are three issues it must consider in determining how much oil to pump.

First, the Saudis want to maintain demand. They do not want to lead the world into a global recession, since that would reduce demand and decrease prices. They are clearly watching the global picture carefully, and we would think that what they are seeing is that any further increase in oil prices would lead to a serious recession. They are indicating that they will try to increase production so that oil prices don’t go any higher and perhaps increase production in the face of softening demand, allowing prices to go down a bit. Oil markets are acting as if this were the case, but the Saudis are too smart to pay much attention to the day-to-day fluctuation of oil markets.

Second, the Saudis have limits on what they can produce. In the short term, their productive capacity has some give in it, but it is not infinitely elastic. They need to be careful not to max out capacity. There has been much discussion of peak oil – the idea that the Saudis have peaked out in their oil supply. If that’s true, then they need to get the maximum price for every barrel produced. It could be argued that keeping prices high even in the face of global depression, if it could be done, would be the optimal long-term strategy for the Saudis. If peak oil is true, then the Saudis need to maximize the total revenue captured, not quarterly or annual revenue.

But the Saudis need to be aware of the third variable: alternative sources of oil and alternative energy supplies. The higher the price of oil goes, the more incentive there is to use previously uneconomic sources of oil and find other energy sources. This is not something the Saudis, or other oil producers, want to see happen. Over the long term, to the extent that they can control prices, the Saudis and others want the highest possible price that precludes significant investment in alternatives. That isn’t easy to calculate or to do, but it is their goal.

Thus, what the Saudis want is the highest possible price. The Riyadh conference affirmed that, but it also seemed to understand that the term “possible” is complex and flexible. If we can extract any meaning from this conference, it would appear to be that the Saudis do not want to see a major break in prices, but are probably wary of seeing the price going much higher and might prefer moderately lower prices to achieve their ends. But it is not clear to us that the Saudis really have that much control over markets, so their finely tuned wishes and reality might not be connected.
June 23, 2008

2008 Braden Prize in Mathematics winners
Congratulations to Allison Hasegawa and Aaron Fong, the 2008 Braden prize winners. Allison will be going to Colorado College and Aaron will be going to Pomona College.
Independence day quiz
See how you do on this test: 24 out of 30 is considered a passing grade. 96% of all High School seniors FAILED this test…
AND If that’s not bad enough — 50+% of all individuals over 50 did too!!

Take the test and be surprised at what ‘we’ don’t know.

Inspired by debates they had while carpooling in a hybrid car, management professors Richard Larrick and Jack Soll ran a series of experiments showing that the current standard, miles per gallon or mpg, leads consumers to believe that fuel consumption is reduced at an even rate as efficiency improves. People presented with a series of car choices in which fuel efficiency was defined in miles per gallon were not able to easily identify the choice that would result in the greatest gains in fuel efficiency.

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