Oil prices have been coming down since the middle of this year. There are several reasons for the same, as I explained in a piece yesterday. One reason being suggested is that it is in the interest of both the United States as well as Saudi Arabia that oil prices go lower than they currently are. Further, these countries might even be colluding to ensure that oil prices are driven lower.
Before we get into the details, it is important to discuss some history here. At the end of the Second World War, the American President Franklin Roosevelt realised that a regular supply of oil was very important for the well being of America and the evolving American way of life. He travelled quietly to USS Quincy, a ship anchored in the Red Sea. Here he was met by King Ibn Sa’ud of Saudi Arabia, which was by then home to the biggest oil reserves in the world.
The United States’ obsession with the automobile had led to a swift decline in domestic reserves, even though America was the biggest producer of oil in the world at that point of time. The country needed to secure another source of assured supply of oil. Hence, in return for access to oil reserves of Saudi Arabia, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud.
Over the years, Saudi Arabia has also ensured that Organization of Petroleum Exporting (OPEC) continues to price oil in US dollars. This has been a major reason behind the American dollar continuing to be the international reserve currency. Given this, the United States and Saudi Arabia have always had a close relationship which has proven beneficial to both the countries.
The recent past has seen the rise of the Islamic State of Iraq and Syria (ISIS) which is trying to redraw political boundaries in the Middle East. As analysts of Bank of America-Merrill Lynch points out in a report titled Does Saudi want $85 oil? “Recent advances by the Islamic State in Syria and Iraq have disrupted Middle East politics. The Islamic State aspires to bring any areas where Muslims live under its control…[It] rejects political divisions established by Western powers at the end of World War I.”
This scenario has led to a situation where Saudi Arabia is cooperating with the United States to keep oil prices down. Typically, oil prices start to rise at the sign of the slightest trouble in the Middle East. Nevertheless, that hasn’t happened this time around. The major reason for the same is that the ruling clan of the Sa’uds wants the United States to keep the security guarantee that Roosevelt gave them, going. In fact, in September before addressing the United States on the threat of ISIS, President Barack Obama is supposed to have called up Saudi Arabia’s King Abdullah Bin Abdulaziz Al Saud.
The ISIS has captured oilfields in Syria and Iraq. This oil is sold at a discount to the world price of oil, to Turkey, which in turn, resells it in Europe. It is estimated that ISIS earns around $3 million from oil sales. By driving down price this earning can be driven down as well. Hence, United States and Saudi Arabia can ensure that they are able to cut down the funding of ISIS.
And how is this being done? Typically, whenever oil prices start to fall, Saudi Arabia starts to cut down on production, so that oil supply comes down, and this immediately slows down the fall in price. But that doesn’t seem to have happened this time around. As the Bank of America-Merrill Lynch analysts point out “We have yet to see a Saudi output cut in response the lower prices. Oil has fallen $15/bbl[barrel] from a peak of $115/bbl in mid-June, but Saudi production has not bulged.”
This has helped keep oil prices down. The threat is that ISIS might want to go beyond Syria and Iraq in the days to come. “It should perhaps not come as a surprise that the threat of a stateless group that challenges the status quo by attempting to redraw national borders is shifting incentives for key regional and global players…The Islamic State could present a direct threat to the Arab monarchies at a time of growing social discontent…In our view, Saudi and other regional rulers may prefer to reengage the US to help protect established borders from the expanding caliphate. What could Arab countries offer the West to help contain this threat? Lower oil prices,” the Bank of America-Merrill Lynch analysts point out.
An interesting comparison to this situation is the time when Iraq attacked Kuwait more than twenty years back. As Thomas Piketty writes in Capital in the Twenty-First Century: “If the United States, backed by other Western powers had not driven the Iraqi Army out of Kuwait in 1991, Iraq would probably have threatened Saudi Arabia’s oil fields next, and it is possible that other countries in the region, such as Iran, would have joined the fray to redistribute the region’s petroleum rents.”
This explains very well, why Saudi Arabia needs the security guarantee from the United States, and in return it is offering a lower price of oil. A lower oil price also helps the United States and other western powers neutralize Russia, which in 2013 was the biggest producer of oil in the world, having produced 13.28% of the oil being produced globally.
There are other political factors at work as well. The Kurds have been demanding autonomy from Iraq and are being allowed to sell oil at a lower price. As Vijay Bhambwani, CEO of BSPLIndia.com explains “The Kurds have started selling high quality arab light grade sweet crude at US$ 55 / barrel. Initial despatches were to Israel. Since the Kurds have a militia of 55,000 strong fighters (Peshmerga) which is funded by oil sales, the western countries are allowing the Kurds to sell their oil below market prices in return for fighting the ISIS forces.”
Over and above this, there is the case of Iraqi cleric Muqtada Al-Sadr, son of the slain chief cleric of Iraq under Saddam Hussein’s rule. As Bhambwani explains “Al-Sadr is the founder / commander of the Mehdi army which is dominated by Shias and is pro Iran. If he seizes power, he is likely to re-negotiate oil contracts with the west, keeping the Saudis on tenterhooks. Saudis are therefore open to hiking output and cutting prices.”
In fact, by cutting the price of oil, the Saudis also hope to neutralize the shale oil boom in the United States and Canada. This boom has led to the United States and Canada producing much more oil than they were a few years back. Data from the U.S. Energy Information Administration shows that United States in 2013 produced 12.35 million barrels per day. This is a massive increase of 35% since 2009. In case of Canada the production has gone up by 22.8% to 4.07 million barrels per day between 2009 to 2013.
But shale oil is expensive to produce and it is financially viable only if oil price remain at a certain level. As Bank of America-Merrill Lynch analysts point out “With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
In the end, there is enough evidence to conclude that Saudi Arabia has been working towards pushing down the price of oil, in order to ensure that the United States security guarantee continues.
The article originally appeared on www.FirstBiz.com on Oct 8, 2014
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)