Streetwise Professor

November 10, 2014

The Saudis: Crazy Like a (Desert) Fox?

Filed under: Commodities,Economics,Energy,Politics — The Professor @ 11:53 am

The recent decline in oil prices, and the failure of Saudi Arabia to cut output has led to many to conclude that the Saudis are trying to drive down prices in order to drive out shale production. I am extremely skeptical, because this would be crazy. It would only make sense if the Saudis are trying to convince shale producers that they are in fact crazy.

The alleged Saudi strategy is a variety of predatory pricing, and such strategies have major problems. Most notably, in the case of shale, driving down prices today would not eliminate any oil that’s in the ground. It would not eliminate drillers’ knowledge about the oil and how to get it out. Perhaps low prices will induce shale producers to delay drilling, and idle some rigs. But as soon as the Saudis cut output in order to cause prices to rise, the shale producers can restart their drilling programs, and under the theory that shale production is keeping prices lower than the Saudis like, this restart will keep prices rising to the level that the Saudis are targeting.

If the Saudis keep prices low for a considerable period of time, some resources (notably labor) may exit the US shale sector, and it may take some time to ramp up production again. But even so, the period of time during which the Saudis can suppress US shale production is limited. The oil ain’t going anywhere, and US producers will bring it out of the ground when the price is right. The Saudis can’t do anything about the fact that the right price for US shale producers is lower than the price they would like.

In brief, predatory pricing requires the predator (KSA in this instance) to suffer losses during the period when it is waging a price war: price wars are costly. But since the price war does not destroy competitive capacity, but just idles it (if that), there is only a very limited period-and perhaps no period at all-during which the predator can sell at higher prices to recoup these costs. This is why predation is usually a losing strategy.

This isn’t a new story, either the predatory pricing argument or the economic retort. Standard Oil was widely believed (based on the tendentious writings of Ida Tarbell, in particular) to have engaged in predation. But John McGee showed more than 50 years ago that this was a fairy tale that did not correspond with the facts.

The analysis above is based on the assumption that everyone is rational and everyone knows everyone is rational. In the 80s, game theorists altered these assumptions and showed that when there is a positive probability that a large firm (e.g., KSA) is irrational and likes to engage in price wars for the fun of it, predation can become a rational strategy by a non-crazy firm. A rational firm can get a reputation for being crazy by preying on competitors. Not wanting to fight crazy, competitors exit or don’t enter.

This theory, like a lot of game theory is quite elegant. And like a lot of game theory, it doesn’t appear to describe anything in that actually happens in reality. Price predators have been very rarely observed in the wild, and arguably they are like the monsters at the edge of pre-Columbian maps.

I am therefore very skeptical that the Saudis are crazy, or acting crazy. This is particularly true given that there is a rational explanation. Given the Saudi market share, and the elasticity of demand for oil, the demand for Saudi oil is elastic. Given that marginal cost is likely very inelastic, it may not reduce output much at all even in the face of a demand decline. Indeed, US shale supply has likely increased the elasticity of the Saudi net demand curve.

I’d also note that there have been stories recently about how some countries, including India and Indonesia, are using the current low prices as an opportunity to cut subsidies. Subsidies have made demand more inelastic (because subsidized consumers get the price signal): reducing or eliminating these subsidies will make demand more elastic.

Greater net demand elasticity, due to greater elasticity of US supply, reduced subsidies, or both, reduces the Saudi incentive to cut output.

Recall that during the financial crisis, even though prices fell about 70 percent from peak to trough, world oil output fell only about 3 percent from its high in July, 2008 to its low in March, 2009. Saudi output fell somewhat more, about 12 percent, but given that the current demand decline is far smaller than observed at the depths of the crisis, and that (as just noted) fundamental conditions have changed so as to reduce Saudi incentive to cut output, the lack of output cuts in the current weak market doesn’t require an explanation based on predatory pricing strategies.

In sum, it is highly likely that the Saudis are not crazy, and aren’t acting crazy, but are instead responding rationally to existing market conditions. Predatory pricing stories should always be viewed with suspicion, because they are seldom ever true. That’s almost certainly the case here too.

 

Print Friendly

21 Comments »

  1. @SWP: Do you think there is any merit to the argument that the Saudis are enabling low prices as a means to put pressure on Russia and Iran, or is this just pure economics?

    Comment by JDonn — November 10, 2014 @ 1:07 pm

  2. I assume Saudi pricing strategy is not about shale oil, but strategic priorities. It wants Iran to earn less money so it’s ability to fund proxy wars against Sunnis are reduced. I had not thought about the subsidy angle, but now it seems a low oil price might help those Arab countries without oil that are subsidizing fuel (like Egypt) and thus reduce their burden and help keep social peace (also means Saudis don’t have to give those countries as much aid to keep them afloat).

    Comment by Chris — November 10, 2014 @ 1:36 pm

  3. I do not know if there is any merit to these allegations coming from the restless mind of armchair generals. But let me tell ya, they sure do make for entertaining conversations, of the ‘’yes, but what if’’ variety. But let’s face it, Saudis are not afraid of shale oil, Russian oil, or Kazakh oil, they’re afraid that too high of a price will accelerate a substitution effect into alternative energies. That would be irreversible.

    Comment by NiCMeF — November 10, 2014 @ 6:04 pm

  4. Has the ISIS supply contributed to the lower price? They have captured oil fields but have to take a lower price, their fence can only offer a lower-than-market price. Then the fence probably has good reason to move that oil quickly. Prices really started to move lower when ISIS became a (black) market player.

    Comment by Richard Whitney — November 10, 2014 @ 9:16 pm

  5. @Richard. No. ISIS has zero to do with it. The world price is determined by the quantity of output that reaches the world market. If anything, ISIS’s control of the Syrian oil fields has reduced output, and elevated the world price. ISIS is forced to sell at a discount to reflect the costs and risks that the middlemen face in marketing the oil.

    The ProfessorComment by The Professor — November 10, 2014 @ 10:36 pm

  6. Not only is the Kingdom not crazy, but their “price war” is bringing some economic reality to a market warped more my cartels and geo-politics than supply&demand. It is an inevitable development, and a long-time coming. Recent Saudi discounts for US deliveries reflect market fundamentals (delivery volumes dropped more than 70% in last year), and the Saudis INCREASED prices for Asian and European deliveries – relative to Brent, also reflecting economic fundamentals. It is economic sanity by the Kingdom, just as SWP describes.

    It is a curious case of double-speak, when OPEC (a self-described nefarious cartel) is so established in the mainstream media as a harbinger of stability, that they can be “accused of predatory pricing”. How twisted is that? You can’t make these idea up? it is beyond nonsense.

    Comment by scott — November 11, 2014 @ 5:45 am

  7. There’s a simple explanation for Saudi pricing cuts to the US: They’re reversing the ones they put in place earlier this year when they wanted to divert more crude to their domestic market.

    Aramco raised US formula prices by $2/bl between January and July. This cut led to a 400,000 b/d drop in US imports of Saudi crude in May-August compared with January-April. Saudi utilities burned an extra 400,000 b/d of crude in their power plants in May-August compared with January-April.

    Comment by Down With This Sort Of Thing — November 11, 2014 @ 8:16 am

  8. […] pay his wife $973 million in their divorce (previously). Saudi Arabia is probably not engaging in predatory pricing. AOL employs a digital prophet to “listen to where media is headed and figure out how our […]

    Pingback by Levine on Wall Street: Rigging FX and Defining Insider Trading | Forex — November 11, 2014 @ 4:01 pm

  9. @SWP…I understand that price is determined by the quantity of oil reaching the market. I am not sure that ISIS has reduced that supply; perhaps they have.
    But if I took the oil fields of, say, Venezuela, by force, and then with basically a zero basis, and sold it for, say, $40 per barrel (all profit to me, and quick), wouldn’t that lower the bid?

    Comment by Richard Whitney — November 11, 2014 @ 4:03 pm

  10. @Richard. Nope. Price is determined by the marginal barrel. Your charity would not affect that, unless you also increased Venezuelan output.

    The ProfessorComment by The Professor — November 11, 2014 @ 4:32 pm

  11. Many of the shale producers in the US are highly levered. A period of weak pricing will discipline producers and their bankers.
    When banks get scared, they make downward credit line redeterminations and employ absurdly conservative assumptions. Cutting financing to your competition does buy at least a few years of respite for the Saudis.

    Comment by Rich L — November 11, 2014 @ 8:11 pm

  12. Why give so much credit to the Saudis or any economic/geopolitical policymaker? Why assume they intend and can predict the effects of their actions?

    I think Yamani’s “no more Saudi floor” was just eternal jawboning so the Saudis don’t cut alone. Unexpectedly and unfortunately, they spooked the market.

    The 100x paper market [mis]took pulling the floor out from under it as you’d expect. Traders (more likely pressed by their auditors) either had to dump longs or buy puts. All in an orderly fashion that will take ~60 days before crude can recover.

    Comment by Robert in Houston — November 12, 2014 @ 7:52 am

  13. I am not sure that ISIS has reduced that supply; perhaps they have.

    They have. Total’s Syrian production was somewhere around 100kbpd before the war, and ISIS have gotten their main plant up and running to the tune of about 10kbpd. Amusingly, ISIS are actively recruiting petroleum geologists and reservoir engineers from the international labour pool. For a terrorist organisation, they are surprisingly good at the day-to-day running of things, compared to (say) the clowns in East Ukraine who seem to be good at wrecking stuff and shooting down airliners.

    Comment by Tim Newman — November 12, 2014 @ 8:37 am

  14. @Tim-re clowns in E. Ukraine. Breathing through the mouth limits the oxygen that reaches the brain, so you have to make allowances.

    The ProfessorComment by The Professor — November 12, 2014 @ 9:11 am

  15. @Prof, indeed. The knuckles permanently dragging on the floor don’t help much either.

    Comment by Tim Newman — November 12, 2014 @ 9:17 am

  16. @Robert. I don’t give credit. The point of the post was to call bull on those who do.

    The ProfessorComment by The Professor — November 12, 2014 @ 9:20 am

  17. @Rich. Yes, they slam on the brakes when prices fall, but they are perfectly capable of stepping on the gas when the prices rise again. No way that there would be a dearth of capital in shale if prices spike back up again.

    The ProfessorComment by The Professor — November 12, 2014 @ 9:21 am

  18. i dont find it crazy, actually crazy were recent oil prices.
    Question is how long can saudis retain their current markets at this or even lower prices, if say 30, 40, 50 years than it’s worth the efforts to keep them lower rather than lose part of it to shale firms.

    Comment by erik — November 12, 2014 @ 10:01 am

  19. […] Saudi Arabia is using a predatory pricing strategy to drive shale producers out of business (“The Saudis: crazy like a desert fox?” Nov […]

    Pingback by Massenbach-Letter: NEWS 14/11/14 | Massenbach-Letter — November 12, 2014 @ 11:53 pm

  20. I wonder if Professor may be willing to comment on the latest developements here.

    Comment by LL — November 28, 2014 @ 3:27 pm

  21. @LL-What developments in particular?

    The ProfessorComment by The Professor — November 28, 2014 @ 3:52 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress