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Saudi Arabia is about to test western free market economics

In Britain, the EU and USA, we tend to leave our future energy supplies to the “free market”.  It is true that governments provide exploration grants and subsidies to oil and gas producers.  Nevertheless, decisions about where and when to drill are left to the directors of the energy companies.

Saudi Arabia, in contrast, makes little distinction between state and market.  Decisions made within the board of Saudi Aramco are almost always in step with state policy.  And what we have been witnessing for the best part of two years now is the unfolding of Saudi Arabia’s long-term plan.

First, faced with competition from the US shale patch and the Canadian tar sands, Saudi Arabia chose market share over price.  This is hard to fault, since there is no rule of business that I have ever heard of that says that when a competitor opens up shop across the road, you are just supposed to pack up and go home.  If US oil companies and the Wall Street banks that financed them were dumb enough not to factor competition into their business models that is their problem.

The collapse in oil prices has had a very noticeable effect on western free market oil companies – they have stopped exploring and they have stopped drilling.  As Julian Lee at Bloomberg points out:

“There are too few new projects being sanctioned by non-state oil companies to offset the inevitable decline in output from existing fields and to meet additional demand. This is expected to increase by 1.2 million barrels a day each year for the rest of the decade. New fields due to start producing this year and next are the result of investment decisions taken when oil was about $100 and expected to stay there. The collapse in company spending is illustrated perfectly by the level of drilling activity. After all, if you don’t drill, you can’t get the oil out of the ground.”

This process is close to its conclusion and it doesn’t end well for the West.  In the UK, the once profitable North Sea is a basket case.  Even big corporations like Shell and ConocoPhillips have pulled out.  What remains is now valued at less than retailer M&S.  From providing the UK Treasury with an essential stream of tax revenue, North Sea oil and gas now need tax breaks, grants and subsidies to keep going.  In the US, the shale patch is limping on, although new drilling has all but ceased.  With a presidential election looming, none of the Wall Street banks wants to be the first to pull the rug out… at least until a safe Washington insider has been installed in the White House.  Whether they can prevent a collapse is a moot point.  However, banks are reported to have set aside at least $500bn against the likely defaults that are going to happen in the coming months.

The second strand of the Saudi plan is to use the wealth that they have already accumulated from oil to buy out oil refineries in key countries – including the USA – around the world.  Control of this infrastructure will allow Saudi Arabia to artificially rig the cost of refining to favour OPEC oil – other producers will be obliged to pay a premium just to get their oil refined into saleable products.

The third strand (Lee’s second) is to keep drilling.  Faced with sustained prices  below $40, the rest of the world has stopped drilling:

“But one part of the world is bucking the trend and drilling furiously to add the capacity needed when demand once again exceeds supply. Three countries on the Arabian Peninsula — Saudi Arabia, Kuwait and the United Arab Emirates — are seeing near-record drilling rates.”

The new production could add close to a million barrels a day to global oil supplies.  But the aim is not to add to an already dangerous over-supply.  Quite the reverse, Saudi Arabia is calculating that by the end of 2017, when these new supplies come on stream, the world will have already burned its way through the current glut of oil.  With the US frackers, the North Sea and much of the Arctic and deep water production at an end, prices are expected to rise well above the $140 peak back in 2008.

In the clash between western free markets and OPEC state planning, my money is on OPEC.  In the new multi-polar world that is coming, oil-importing countries in the West face an economic crisis similar but larger than the oil shocks of 1973 and 1979.  But this time around, the North Sea, Alaska, the tar sands and the US shale patch will have gone.  This time around, we can expect fuel prices to go up and stay up… at least until Western recessions crush demand once more.

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