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Why Crude Oil $80 Is the New Normal, Reasons Saudi Arabia Will Not “Swing”


Now the dust from the Shock & Awe of the 30% drop in oil prices has started to settle, two things are clear: (a) Saudi Arabia did not engineer anything (b) they don’t have a Machiavellian plan to stick one up the wildcatters in North Dakota, or the Russians…the Iranians…the Venezuelans, or even the genius from the Daily Telegraph who was bemoaning the fact that if oil prices go down it will be hard to import inflation into U.K.
Here are five good reasons why they are going to pass on the opportunity to slash their oil production by 30% so that other OPEC members can cheat and make a windfall, like they all did in 1987/8.


1. Read My Lips

Since oil prices jumped from $80 to $110 in early 2011 the Saudi’s have been saying, over, and over and over again, that oil was over-priced by 20% to 40% compared to what they considered to be the “Fair Price”. Here is the BREAKING NEWS…they didn’t change their mind.

2. They were and still are correct about what is the Fair Price: Parasite Economics Explained

Until “Peak Oil” finally arrives (no sign of that yet), the reality is that the oil producers – particularly the Saudi’s, have the ability to pump more oil than the rest of the world can (sensibly) consume. Think of the world like a cow – the oil producers are parasites living off the milk of the cow, they feed it (oil) and the cow gives them milk (money). What the Saudi’s mean by the “Fair Price” is how much milk they can reasonably expect to drain out of the cow, without it suffering an attack of mastitis. Sure you can feed the cow more hay and alfalfa (oil), but after a certain point, it doesn’t matter how much you feed it, you won’t get any more milk, all that will happen is that the cow will get fat. Historically, when the amount of milk (money) the oil producers pulled out of the cow, exceeded 3.3% to 3.7% of world GDP, the cow started to suffer, inflation went up and GDP stalled. When the amount of milk (money) was less than 3.3% to 3.7% of GDP, investment in infrastructure to maintain and find oil fields, suffered. What the Saudi’s call “Fair Price” is the balance of those two extremes.

3. Saudi Arabia is not in an oil-war or any sort of war with Russia

How about this for war-mongering?
At a news conference after holding talks with the Saudi Foreign Minister Prince Saud al-Faisal in Moscow on Friday (21st November) Russian Foreign Minister Sergey Lavrov, said….“Saudi Arabia and Russia believe that pricing should be market-oriented and let supply and demand play the decisive role. We and our Saudi partners are against shifting markets as result of political or geopolitical schemes” (Reuters)

4. Replacement Cost

If you don’t buy the cow-story, there is another way to value a finite resource that you have and make a decision about what price to sell it for. A good guide is how much it will cost someone else to find and develop oil fields. The boys in North Dakota have demonstrated that you can easily get new oil out of the ground for about $80 a barrel – and still make a profit. So that’s the Fair Price, you can decide, do you sell at that price, or do you hold on and wait until that new oil is pumped, and get a better price. If you find that the other guys are selling at $100, and making a windfall, well you might just decide to make a bit of a windfall yourself. That’s “fair-enough” isn’t it?

5. Saudi Arabia needs to repair/refurbish their oil fields – at $80 they will buy that at half-price

It’s no secret the oil-fields offshore Saudi Arabia are held together with bird-droppings. There is a real danger that at any moment there may be un-seasonal bout of rain, the droppings will get washed-off, and the whole thing will fall to pieces.
The Saudi’s have been talking of spending $100 billion, perhaps $200 billion, perhaps $300 billion, to scrape off the bird-droppings and replace them with steel, put grout-bags on top of their pipelines where all the cement weight-coats are started to dissolve and so they are floating to the surface, and re-drill oil wells that were drilled thirty-years ago, using the latest technology.
But the problem was that once oil prices hit $100 four years ago, everyone went crazy and the cost of renting a drilling rig and all the other paraphernalia you need to scrape off bird-droppings and do other essential maintenance in an oil-field, went through the roof.
Fortunately the Chinese were around. You could wander-by a yard in China, put 1% down, and they would build you a brand new drilling rig. Plenty of people did that, currently there are about 550 offshore drilling rigs in the world (floaters and jack-ups), this time next year there will be 750. This time next year the price to charter one of those will be 50% or perhaps 30% of what it was last year; same story for all of the other paraphernalia. So at $80 oil the Saudi’s will be able to buy the refurbishment they need, at half price.

Don’t expect oil prices to go much above $90 until they are done…in about four year’s time.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe. Ex-Toxic-Asset assembly-line worker; lives in Dubai.

market oracle

10 Comments on "Why Crude Oil $80 Is the New Normal, Reasons Saudi Arabia Will Not “Swing”"

  1. Makati1 on Sun, 23rd Nov 2014 6:47 pm 

    Maybe Andrew is wrong? There is only one business that is more devious and untrustworthy than the oil/NG business, and that is banking. Those two vie for the title of number one liar. All I can say is that in a few years, the real answers may be available. Until then…

  2. shallowsand on Sun, 23rd Nov 2014 9:00 pm 

    Keep the price down to spur future demand would be a reason for countries who rely on oil exports to not cut supply at this time Seems may already be working. More heavy low mileage vehicle sales and less fuel efficient and EV sales already. Also, ethanol spot price is at parity with RBOB. This signals gasoline demand is rising as there is a scramble to buy more ethanol to blend with more gasoline.

  3. Davy on Mon, 24th Nov 2014 5:38 am 

    Shallow, KSA has learned a thing or two over the years with oil and the global economy. For them the wild swings are undesirable. Unless you are a speculator wild price swings are not desirable for a productive concern small business to large corporation. This demand maintenance consideration could likely be their intent.

    It must be apparent to most governments the economy is not healthy. KSA would surely prefer adequate demand with low but acceptable prices over higher prices leading to dropping prices and dropping demand. Demand and price destruction is the killer duo for a commodity producer. Cutting supply as the economy weakens is similar to what the Fed did during the great depression by draining liquidity when they thought there was economic strength only to gut the economy. If there are ancillary results beneficial to their political agenda I imagine this is a further benefit to consider.

    We know from our discussions here the economy is not healthy. Financial repression would not be applied if this were the case. The market bubbles in conjunction with financial repression and artificial liquidity indicate price discovery distortions. Debt beyond any historical example can only point to distortions. KSA, surely realizes that boosting oil prices when global economic demand is unstable could be a dangerous deflationary move if demand were to be destroyed further destroying price.

  4. Makati1 on Mon, 24th Nov 2014 6:55 am 

    Where are there facts pointing to an actual drop in demand this year? A lot of articles talking about the drop, but no figures/statistics to back up their assertions. What countries are buying less now than last year? I see articles about China actually buying more oil, not less, for their stockpiles.

    I have seen no articles anywhere, that show an actual demand drop. Certainly not one to cause a 30% drop in price over a few months.

    Rockman? Short? Anyone?

    2nd question: How long can those oil exporting countries survive on $80 oil when their budgets and lives depend on $100 oil??

  5. rockman on Mon, 24th Nov 2014 11:09 am 

    M – Let’s avoid numbers per se. Difficult to get the real facts. More important is how the facts are interpreted. So let’s look at it from a macro point of view. And we’ll use you as an example: What ultimately determines how much refined petroleum products you and your neighbors consume: how much is available to buy or what the price is? I assume you and yours don’t have an unlimited supply of cash so price is the final determining factor. Granted many will pay whatever the price might be for some of their consumption because they have no choice. Such as drilling to work or running a business. But the non-essential consumption will obviously be driven by price.

    So very simply: does your Esso station price your fuel based upon what it pays for oil or does it price it to sell to you and yours? IOW is Esso going to charge such a high price that it eliminates most of its sales? Obviously not. It lowers the price to max its cash flow. If ExxonMobil knows it can’t recover the costs of $100/bbl oil based upon its forecast of what price of fuel its market will bear it won’t pay $100/bbl. How could it?

    So here’s the problem: if the companies lower prices for refined products demand naturally increases. So you can’t look at demand changes in a vacuum: pricing has to be a component of that equation. Not difficult to imagine current US demand (IOW consumption) for gasoline would be considerably lower today it prices were at the $4.50/gal level it was not too long ago. The same is true for every other region in the world.

    So the bottom line IMHO: demand is obviously much lower because if it wasn’t prices for refined products would be much higher. The KSA can’t charge refiners $100/bbl if the refiners won’t pay $100/bbl. And the refiners won’t pay $100/bbl is the consumers won’t pay enough for the refined products to allow the refiners to make a profit. IOW what business would pay $1 for a commodity, spend $0.10 to convert it into another commodity and then sell that commodity for $.90? And what consumer is going to pay more the $0.90 for that commodity if they don’t have the money to do so and aren’t forced to acquire it?

    It continues to baffle me that so many folks think oil/NG producers are free to charge whatever price they want for their production AND STILL SELL THE SAME VOLUME. Tomorrow the KSA can raise the price of their oil exports to $120/bbl. And would they be selling the same volume of oil as they are now? Obviously not. But they would probably still be selling some but it’s not difficult to imagine their total revenue would be much less then it is today, no? The KSA can set the price and the volume of the oil they sell. But they do not control the price and volume of oil the refiners buy: the refiners make that call based upon what they anticipate the consumers to accept. ExxonMobil et al are not going to buy oil at such a price that after refining it they’ll lose money selling the products.

    Would you?

  6. rockman on Mon, 24th Nov 2014 11:15 am 

    M – “How long can those oil exporting countries survive on $80 oil when their budgets and lives depend on $100 oil??” The short answer: search the history of KSA past budgets and compare it to the oil export revenue. It should be obvious that the KSA budgets levels have always be determined by their revenue. KSA budgets will always be met by their income because those budgets are determined by their income.

    Isn’t your personal budget determined by your income? Or do you have a sugar momma to cover your butt? LOL.

  7. pappadeux on Mon, 24th Nov 2014 12:53 pm 

    rockman> It should be obvious that the KSA budgets levels have always be determined by their revenue. KSA budgets will always be met by their income because those budgets are determined by their income.

    Rock, that is NOT correct

    they heavily borrowed in 90s and paid their debts only recently

    SA Debt/GDP

    Dec. 31, 1999 99.70%
    Dec. 31, 2002 93.74%
    Dec. 31, 2004 62.93%
    Dec. 31, 2006 25.83%
    Dec. 31, 2009 13.99%
    Dec. 31, 2012 03.70%

  8. Mark Ziegler on Mon, 24th Nov 2014 1:02 pm 

    I do not see ExonMobile buying any oil when they can pump it out of the ground for a cheaper price.

  9. Harquebus on Mon, 24th Nov 2014 4:46 pm 

    Milk is not the only thing that comes out of cows.

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