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How Saudi Arabia Benefits From Cheap Oil

Investopedia logoInvestopedia 05-05-2015 Matthew Johnston
Since the middle of last summer oil prices have dropped significantly and many have wondered why the traditional ‘swing producer’ Saudi Arabia has not intervened by cutting production. © Thinkstock Since the middle of last summer oil prices have dropped significantly and many have wondered why the traditional ‘swing producer’ Saudi Arabia has not intervened by cutting production.

Since the middle of last summer oil prices have dropped significantly and many have wondered why the traditional "swing producer" Saudi Arabia has not intervened by cutting production as it did during the Asian financial crisis, the popping of the tech bubble in the early 2000s, and again at the start of the recent financial crisis. In fact, Saudi Arabia has actually just recently increased production to 10.3 million barrels per day, its highest level on record. Although this decision appears economically unjustified, the cost of earning a lower profit margin is being offset by two significant benefits: one is the economic benefit of maintaining market share and the other is the geopolitical benefit of being hurt less by low oil prices than Saudi Arabia’s strategic rivals.

The context: The downward trend in global oil prices

There are both supply side and demand side reasons for the current depressed level of global oil prices. On the supply side there has been the development of American shale oil and the Canadian oil sands, as well as “new supplies from Russia, the Arctic, Brazil, Central Asia, Africa and growing volumes of offshore oil around the world.” There has also been recent “unexpected resumption of oil production in Libya, Nigeria, South Sudan and Iraq,” as well as the possibility of a future boom in Mexican oil production.

On the demand side the slowdown in growth in both China and Europe has meant a decreased demand for oil. Technological advancements leading to increased energy efficiency have had a negative effect on global demand for oil. Given this situation of increased supply and decreased demand for oil, Saudi Arabia is taking advantage of the benefits that a lower oil price provides.

Economic benefits for Saudi Arabia

As Saudi Arabia faces increased competition from international competitors like American shale oil drillers, the Saudis are much more concerned about maintaining market share than in previous years. Since shale production in America is more costly than Saudi Arabia’s oil production, the Saudis can still profit from lower oil prices where American producers would be taking a loss. Reuters reports in 2014 that the average estimates of the marginal cost of producing one new barrel of oil are between $70 and $77 per barrel for US shale oil whereas the marginal cost for Middle East Onshore oil production is between $10 and $17 per barrel. The Saudis are effectively driving these higher-cost American producers out of the market by keeping prices lower, thus maintaining a greater share of the market.

Geopolitical benefits for Saudi Arabia

Although maintaining market share at the expense of American producers, both Saudi Arabia and its ally the United States benefit geopolitically. As Phil Leech of Capital As Power says, "The cut in prices clearly harms all producers by reducing the amount of profit per barrel, but it certainly harms some more than others. For example as demonstrated by The Economist recently, the current oil price has dropped below the ‘break even price’ for all major suppliers (with the exception of Kuwait), and this includes the traditional ‘swing producer’ Saudi Arabia. But the drop is far more damaging to several international actors, most of whom happen to be strategic rivals to either Saudi Arabia, and/or its closest ally, the US (e.g. Russia, Iran and the Islamic State)."

As of October of last year, Saudi Arabia’s breakeven point was less than Russia and Iran, as well as the Islamic State occupied area of Iraq. Although Saudi Arabia is currently above the breakeven point as well, it is in a much better position than its rivals.

What is interesting is that Saudi Arabia’s decision not to cut oil production to prop up prices comes at a time when its American ally is in conflict with all three of the above mentioned rivals: conflict with Russia over the annexation of Crimea in the Ukraine; conflict with Iran over its nuclear program; and conflict with the terrorism of the Islamic State. The US has imposed trade sanctionson all three of these rivals; that, coupled with lower oil prices is causing severe economic hardship for these nations, and the hope for Saudi Arabia and the US is that this will cause these nations to make serious concessions to the U.S. led global political consensus.

The Bottom Line

Thus, although suffering from lower profit margins overall, Saudi Arabia is well positioned to benefit both economically and geopolitically by not intervening to prop up global oil prices. Although the lower oil prices mean American shale oil producers suffer and thus cede market share to the Saudis, the US may be more forgiving of its ally due to the geopolitical benefits made for both countries against the strategic rivals of Russia, Iran and the Islamic State.

SEE SLIDESHOW (below): Biggest oil producing countries in the world >>

A look at the world's top oil producers, with the US rising to number two just behind Saudi Arabia. The world's top oil producing countries

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