Kate Mackenzie Saudi Arabia’s crucial role in the crude price outlook

Now that crude oil prices are above $85 a barrel, how can we expect producing countries to react? For most, this is a no-brainer. As The National points out, Russia – currently the biggest exporter – recently achieved a post-Soviet record in crude oil production, while producers such as Syria and Mexico insist they are doing all they can to turn around their declining production. Most Opec members, meanwhile, have for the past year been steadily reducing their compliance to the production quotas agreed by the cartel in late 2008.

That leaves Saudi Arabia. Ali al-Naimi, Saudi Arabia’s oil minister and the unofficial leader of Opec, says many positive things about the $70 – $80 price range that oil futures have traded in over recent months. “Close to perfect“, “a very happy situation” a some of his comments on those prices in the past few weeks alone, and he has been talking about this range for much longer than that.

It’s a well-known Opec phenomenon that while most members break any production quotas to increase their own oil revenues, Saudi Arabia not only adheres to the targets but at times produces even less than its own quota to offset the poor compliance of other Opec states. This is one reason it has become known as the ‘central bank of oil’. The other (related) reason is that Saudi Arabia has more spare capacity than any other oil producing nation, although exactly how much is not completely clear and hotly debated.

Saudi Arabia points out that its goals are not without an element of altruism. The logic is: everyone, regardless of their view of ‘peak oil’, admits that maintaining and growing crude oil production requires significant investment and that a low oil price – even if it reflected current lacklustre demand and high inventories – could do damage to future supply that would play out as an oil price shock in the medium-term. The less altruistic aspect of not pushing prices too high is that at some point, as previous oil shocks have shown, substitution will set in and economic growth will be hurt – in otherwords, the demand destruction that Saudi Arabia and its fellow Opec members are so keen to avoid.

Al-Naimi’s sanguine views on recent oil price ranges have seen him reluctant to point the finger at speculators — in contrast to Opec’s secretary-general, Abdulla el-Badri.

However Reuters’ John Kemp argues that Saudi Arabia’s actions in the past suggest it targets physical oil supply, rather than the market price – raising questions about how it might react to this latest jump, should it continue:

Saudi policymakers have focused on the need to drain “excess” inventories, resisting calls to provide more oil while the physical market remains comfortably supplied. This is exactly the confusion between price and availability targets which contributed to the last spike. Riyadh remains reluctant to add oil when physical availability remains good, even if futures prices are climbing, preferring to wash its hands and blame speculators for the rise.

If the kingdom continues to sit on the sidelines while prices climb towards $90, the market will be primed for a re-run of the events of the 2006-2008. The longer it delays action, the harder it will eventually be to regain control. The more prices rise the more investors will be drawn into the market by the chance to benefit from a momentum trade.

There are arguments about how directly Saudi Arabia can impact the price of oil, but Kemp believes it goes beyond affecting the shape of the curve and it will only have itself to blame if oil prices rise enough to encourage further substitution.

While Saudi Arabia does sometimes exceed the quota limits, the latest estimates from the IEA show it is just within the target range. The question is, what will it do if prices remain above $85?

Related links:

Opec ministers divided: Fundamentals, or a bubble? - FT Energy Source