Keenly aware of whom holds the power in the American-Saudi relationship, the Saudis rebuffed President Bush’s entreaties last week with what has become the standard OPEC line; oil markets are well supplied and they see no need for further production. However, in a half-hearted gesture Saudi Oil Minister Ali al-Naimi announced the kingdom had increased production by 300,000 barrels a day last week in order to compensate for delivery cuts by Venezuela and Mexico. Oil markets reacted by roaring past $127 a barrel to flirt with $128 before sliding back to close just over $126.
While that may be the headline, the question lingers; how did we arrive at this dismal state of affairs? It all starts not so long ago, in a desert far, far away…..
Once upon a time, OPEC and Saudi Arabia in particular, was highly sensitive to the price of oil and its impact on the American economy.
While naturally wanting to get as much for a barrel of oil as possible, they were careful not to kill the goose that laid the golden egg: namely American demand. If prices went too high, demand in America would contract, oil supplies would build and prices would soon deflate. As prices fell, demand would recover, prices would eventually begin another jog northward and the cycle would begin a new. In effect, the price of and demand for oil was on a rollercoaster.
For OPEC members, this was a very volatile and uncertain state of affairs. In order to minimize the havoc the rollercoaster effect wrecked on its members, the petroleum exporting group established a system of production quotas designed to bring relative stability to the oil markets. Members would be assigned a barrel per day production quota that would collectively keep the markets (read America) supplied without creating excessive surpluses, commonly known as gluts.
Gluts led to a freefall in prices and devastated producer’s profits and national budgets. Hence, in OPEC’s eyes, gluts were as equally undesirable as declining demand. Prices go too high, they sold fewer barrels. Too many barrels in the market, they got fewer dollars per barrel. Both affected their bottom lines adversely.
In contrast to gluts are strained supplies and shortfalls. Such events trigger price increases which result in diminished demand and the markets end up back on the rollercoaster they had diligently tried to avoid. In order to prevent another harrowing circuit on the market’s hills and valleys, OPEC had an ace in the hole; Saudi Arabia.
Saudi Arabia, the political and production powerhouse of OPEC traditionally maintained sufficient excess production capacity to step in and stabilize the oil market when global supply was threatened or prices edged too high. When the Iranian Revolution, the Iran-Iraq War and Iraq’s invasion of Kuwait reduced global oil supplies, Saudi Arabia stepped into the breach and literally opened up the spigots. After initial price spikes, Saudi excess production stabilized the markets and prices receded accordingly.
In very real terms, Saudi Arabia’s excess production capacity was a pressure valve for the global oil market. If pressure and prices went too high, the Saudi valve would be triggered. Excess Saudi oil would sate the markets and prices would decline to an acceptable level for both producers and consumers. The Saudis would turn back their spigots as the American and global economy breathed a collective sigh of relief.
The key factor in this equation was always American demand. As the unrivaled consumer of oil globally, American demand in effect charted the course for the global oil market and the price of oil itself.
Though demand in the United States was flat last year, increasing by less than 10,000 barrels a day in an economy that consumes 20 million barrels a day, the price of oil has doubled in a year. Much of this astronomic increase is admittedly due to the decline in the dollar. However, even taking into account the dollar’s weakened state, flat and seasonally reduced demand should dampen oil’s meteoric rise to some degree.
Were American demand still the ruder that steered the course of the oil markets, one would naturally expect this to be the case. However, that was the hallmark of Global Oil Supply and Demand 1.0. Much to the American consumer’s chagrin, those days are gone. That was then.
With the industrialization of the Chinese and Indian economies GOSD 1.0 has become obsolete. Add to the mix the introduction of two billion-plus new consumers, the attendant demand for oil to produce and transport products to them, as well as their growing appetite for personal transportation (read cars) and you find yourself in the new world of GOSD 2.0. This is now.
In GOSD 2.0, the Saudis and OPEC no longer fear declining demand in America. Our anguished cries as oil continues its tortuous ascent fall on deaf ears. Remember, the dollar’s decline impacts oil producers as well as consumers. Not only does it costs us more greenbacks for every barrel of oil, but those dollars are worth less once they make their way into the hands of the Saudis and their OPEC brethren. Costs us more, buys them less.
Next there is the demand aspect of GOSD 2.0. While demand may be flat or declining slightly in the US, it is robust in China, India and the OPEC states themselves. China has experienced a 16.5 percent increase in demand this year alone.
Every barrel of oil America declines to purchase China will be more than happy to pick up. Furthermore, with currency reserves of over one trillion dollars, price is not their primary concern. There focus is on access to reliable and consistent supplies, no matter what the price may be. So long as they’re paying for their oil with the dollars we send them for their products that stock our shelves and fill our homes, they could care less.
Taken in total, a declining dollar and increasing demand from Asia all preclude the necessity of OPEC and our Saudi friends from loosing sleep over American discomfort. So long as the dollar remains weak and the Chinese economy remains thirsty, OPEC will remain nonplused.
Instead of begging the House of Saud to salve our pain, perhaps we should take the admonition “physician, heal thyself” to heart. While high oil and gas prices are the symptom, the declining value of the dollar is the cause. Strengthen the dollar, reduce the price of oil and gas, and relieve the pain.
Mulder said it best, faithful readers. We're not alone. Stay tuned for further updates as prices soar and tears pour.