Possible Effects on the World Oil Market

Abstract from "The Future of the Saudi Arabian Economy. Possible Effects on the World OilMarket", Reports 2000/7, Statistisk sentralbyrå.

Saudi Arabia has been well endowed by nature regarding oil resources. This has enabled the country's population to enjoy a standard of living higher than they otherwise would be capable of. There exist almost no export besides oil, and domestic supply of tradeables is very low. Domestic demand is kept afloat by government budgets, but since 1985/86 the government budget and the current account has been in deficits. This has restricted the government's prospects in policy-making. The economy has developed poorly during the 1990's. GDP per capita has been stagnant or even declining and severe financial imbalances have emerged. The country has a political and social structure that is probably not adequate in handling severe economic problems that cannot be eschewed much longer. This may lead to substantial changes in policies but also to changes in government that are very difficult to predict. This study focuses on alternative economic and political developments that may shape the future of Saudi Arabia. The first alternative serves as our reference case. No major changes in government policy or oil policy are assumed. Likely or not, historical trends are carried forward. It rather shows that something needs to be done because of poor economic results for the country as a whole. In the second alternative we assume that Saudi Arabia will enter WTO, and therefore will reduce subsidies, privatise and introduce taxation in order to increase non-oil revenue of the budget. The third scenario is more dramatic in term of oil policy. Lack of funds enforces the government to take on a more aggressive oil policy in an attempt to avoid financial imbalances.

We assume that OPEC changes its policy in 2000. Higher output and lower oil prices have effects on the world economy due to the importance of oil as a world commodity. To be consistent we should in principle change our assumptions of GDP-growth that drive demand. Given the results we have in the market grab scenario compared to baseline, these effects will be very small and are neglected for simplicity. In their most recent Economic Outlook, OECD shows the effects of a permanent increase in the crude price of 10 USD. The effect on OECD GDP seems to be - 0.3 % while consumer prices increase by 0.8 %. The price effects we arrive at are only half of this. Thus we neglect the effect on the OECD area.

If we focus on long-term results we notice that the crude price (both nominal and real) is reduced by some 2.5-3 USD per barrel and OPEC output has expanded by 5 mbd in line with capacity. The supply response to lower prices in non-OPEC countries is very small according to our model. In itself this makes it less likely that higher output will be optimal for OPEC according to our theoretical discussion above. One argument in favour of this result and in line with our model is that as long as prices are as high as in both scenarios, operating costs will be covered for most non-OPEC producers. Thus the rent is reduced but it still pays to produce roughly as before at least on already developed sites.

For OPEC as a whole, gross revenue in 2010 is 897 mill. USD per day in this scenario as opposed to 888 mill. USD in baseline. If we assume that marginal costs in OPEC are 2 USD per barrel, net revenue in 2010 is slightly higher in the baseline scenario than in this market grab scenario, roughly speaking they are the same in both. However, if marginal production costs are much higher because the increase in OPEC output is spread among many OPEC countries and not those with the lowest costs, it clearly does not pay to expand output according to our model. Beyond 2010, the effect on the crude price is somewhat lower than in 2010 and higher output is then more likely to be beneficial to OPEC. On the other hand, the lower price applies to a higher output as OPEC capacity is assumed to increase beyond 2010. Thus also in 2015 the difference in gross revenue is very small between the two scenarios according to our simulation results.

Taken as an investment strategy, any increase in net revenues will have to be discounted against the loss in revenues that comes during the first ten years or so. Notice that the crude price drops considerably during these years, before gradually stabilising at 2.5-3 USD lower than in baseline. For many years this market grab scenario actually implies a decline in the crude price compared to the average price in 1999 (18 USD). In 2002 and 2003 the crude price is around 16 USD per barrel and the loss in revenues for OPEC is very large in the market grab scenario compared with baseline during the first years. Since the cost of market grab come early and possible increases in net revenue much later, the market grab scenario does not seem an optimal policy for OPEC as a whole according to our model.

So far, we have discussed the market grab scenario as if it applied to OPEC as a whole. Now suppose that only a few countries within OPEC actually have the potential to increase their crude production considerably. Suppose further that these countries also are low cost producers. In fact this is just what is true of countries such as Iraq and Saudi Arabia. It is not clear how fast Iraq can increase its output, but there is little doubt that Saudi Arabia can increase output from around 8 mbd that is close to present production to say 14 mbd by 2010 (assuming growth in baseline with a constant quota within OPEC in addition to 5.4 mbd according to table 5.2.). In 2010 Saudi gross revenue is estimated at 234 mill. USD per day. In the market grab scenario gross revenue would be 318 mill. USD a day and taking into account a marginal cost of producing the extra 5.4 mbd at 2 USD a barrel would give a net increase in revenues of (318 - 2*5.4 - 234) 73 mill. USD a day. For Saudi Arabia there would hardly be any short run costs to this strategy. Thus if Saudi Arabia could increase it production while the rest of OPEC did not, Saudi Arabia would economically benefit a lot from such a policy. But taking into account the results for OPEC as a whole, roughly all of the Saudi benefit would be at the expense of other OPEC member countries. It is thus not likely that OPEC would survive if such a policy were to be undertaken by the Saudis. Obviously this would also change the whole political scene in the Middle East and within the "Arab nation".

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