Saudi oil and Congress

May 26, 2008
Oil consumers have reason to feel relieved that Saudi Arabia hasn’t increased production by more than the 300,000 b/d now widely disparaged as inadequate.

Oil consumers have reason to feel relieved that Saudi Arabia hasn’t increased production by more than the 300,000 b/d now widely disparaged as inadequate. They also have reason to cringe after the latest energy abomination from the US Congress: passage by the House of a bill empowering the Department of Justice to take antitrust action against the Organization of Petroleum Exporting Countries.

Yes, the market needs more oil. But it needs lighter and sweeter crude oil than what will become available from any immediate Saudi production hike. The market also needs enough production potential in reserve to meet demand surges and supply disruptions. And consumers need energy governance based, for a change, on an adult view of these complexities.

Too small?

US President George W. Bush received news of the Saudi production increase on May 16 during a visit to Riyadh at which a request for more oil topped the agenda. Most analysts deemed the increase too small to reverse the recent surge in crude oil prices. Indeed, on the day of the announcement, the futures price of light, sweet crude set yet another record. It has increased since then.

The price increase can be seen as substantiating the inadequacy of Saudi Arabia’s gesture. So suspicion builds that the desert kingdom is restricting supply to drive up the price of oil—suspicion manifest in the heavy margin by which the House approved antitrust litigation against OPEC. But a different explanation deserves notice.

A production increase of 300,000 b/d may be all Saudi Arabia could have implemented without spooking the market and driving up prices even more. The Saudis have a longstanding policy of holding 1.5 million b/d of production capacity idle as a supply buffer. This is deliberate production restraint. But it helps consumers by providing a measure of market stability.

According to International Energy Agency and US Energy Information administration data for April, the new output increase pulls spare Saudi production capacity close to the 1.5 million b/d minimum. Idle capacity scattered elsewhere in the world, all within OPEC, totals 500,000-800,000 b/d after deductions for countries where political unrest makes production hikes improbable. The total is barely enough to cover loss of production from, say, Venezuela or Nigeria. The market stays jumpy when spare production capacity is this low. A production hike much greater than 300,000 b/d would have brought the important Saudi buffer below its floor level and legitimately alarmed traders.

Another reason the Saudi increase didn’t lower reported oil prices is that marker crudes—the ones that make headlines—are the light, sweet oils that the market increasingly craves and not the heavy, sour oil available from incremental Saudi production. To sell the new oil, the Saudis will have to discount it enough to encourage purchases for storage. The price effect will be a widening of the spread between low and high-quality grades. The volumetric effect will be a shift in low-value oil from one market cushion, idle production capacity, to another, inventories. The jump in marker prices after the Saudi announcement makes evident that the market considers a reduction in spare production capacity more significant than low-value oil headed for storage.

Relaxation in sight

Relaxation of this anxiety is in sight. Production capacity will increase soon as major projects come on stream in Saudi Arabia and other members of OPEC. For consumers distressed by high oil prices, this is excellent news. Increased supply and expansion of market buffers are essential to price relief. And global demand growth is slowing.

The market will need even more new supply in the future—supply that will result from investments planned now. With its misguided bill targeting OPEC for antitrust harassment, Congress has given group members a strong reason to chill their investments. Lower investment means lower future supply in a market under pressure, from population growth and industrialization, to expand. The combination is a formula for oil prices higher than they would be if Congress acted as though it knew something about the oil market and genuinely cared about the interests of consumers.