Saudi oil policy

CGES | OCTOBER 2007 | SOURCE: Global Oil Insight

At the beginning of last year OPEC’s basket price was below $60/bbl, but by the end of the summer of 2006 it was nearer $70/bbl. At the start of this year the basket price was even lower, hovering just above $50/bbl, but once again the price of oil was much, much higher by the end of this summer, reaching almost $75/bbl.

The question that springs to mind is what part did Saudi Arabia — OPEC’s major producer and policy leader — play in causing the oil price to rebound on both these occasions?

If Saudi production cutbacks had, indeed, a lot to do with the observed oil price increases, it would be interesting to try to infer from the pattern and timing of these output cuts the Kingdom’s target price over the period.

The Saudi oil minister, Ali Naimi, and a number of OPEC officials kept repeating over many months that the market was well supplied with oil and that the high prices were due to speculation and US refining bottlenecks.

However, a close inspection of Saudi Arabia’s monthly oil production figures since January 2006, as estimated by the CGES, paints a different picture. In the first quarter of 2006, Saudi oil production was consistently above 9.5 mbpd at a time when the OPEC basket price was averaging around $58/bbl and the Kingdom’s formal output quota stood at 9.1 mbpd.

From our analysis of likely Saudi budgetary requirements in 2006 we understood at the time that the Kingdom needed an OPEC basket price above $50 a barrel to meet its projected expenditure needs.

Evidently, in view of the subsequent cuts in oil production effected by Saudi Arabia, this price (of $50/bbl) was deemed insufficient, requiring a change in output policy.

Cutting production

Rather than push such a change formally through the OPEC quota system, Saudi Arabia seems to have preferred to reduce its oil production unilaterally, hence the cuts instituted in April and May ’06 (see Figure 1).

The Kingdom reduced itsoutput of crude oil by 360,000 bpd in April and another 150,000 bpd in May ’06. Saudi oil production rose in the three subsequent months, bringing output back to the April level by August ’06, but this was due to the Kingdom’s higher seasonal use of crude oil in power generation during the very hot Saudi summers.

Output in September was 100,000 bpd down on August and in October there was a further 100,000-bpd reduction. It should be noted that the overall Saudi output reduction of 640,000 bpd from March to October 2006 had not been decreed by OPEC, but had been instigated by Saudi Arabia entirely of its own volition in a drive to raise oil prices.

This policy was in fact very successful, pushing the OPEC basket price up to almost $70/bbl in July and August 2006. The subsequent heavy fall in the oil price in September and October ’06, due to a build up in oil inventories and a mild autumn in the
Northern Hemisphere, provided the backdrop to OPEC’s decision to cut its collective output by 1.2 mbpd from November ’06 onwards, followed by another cut of 0.5 mbpd from February 2007 onwards.

Considering that Saudi Arabia had already reduced its oil production substantially before the advent of OPEC’s 4Q06 and 1Q07 formal cuts, it was surprising to see the Kingdom cut its output further, from 8.89 mbpd in November ’06 to a low point of 8.53 mpbd in April 2007.

There can be but one explanation: Saudi Arabia was determined to get the OPEC basket price back up above $60/bbl, which was achieved in April this year, and the price has not dropped below this threshold ever since.

Between November ’06 and April ’07, the nine OPEC countries in the quota system excluding Saudi Arabia reduced their collective output by 383,000 bpd. For its part, the Kingdom cut its production by 360,000 bpd over the same period, but we must remember that it had already slashed its output by 640,000 bpd between March and October ’06.

To put the story in a nutshell, the evidence suggests that Saudi Arabia reduced its oil production by no less than 1 mpbd between March ’06 and April ’07 in pursuit of oil prices above what emerges as the Kingdom’s floor price of $60/bbl for the OPEC basket of crudes.

Price discounts on Saudi heavy crude

Saudi Arabia exports most of its crude oil by means of term contracts at market related prices, but with destination restrictions, because different price formulas apply to the marker prices at the various destinations. In the middle of the month prior to lifting, the contract holders begin discussions with Saudi Aramco about the amount of oil they would like to lift in the following month and where they intend to take this crude.

Two key factors help to determine the amount of crude the contract holders would wish to lift from the Kingdom: their own need for Saudi crude of a particular quality and the price they are likely to have to pay for this oil. Each lifter’s actual crude requirement is not publicly known.

What is also not known is the price the lifter will eventually have to pay for the oil, not because it is secret but because it depends on the market price prevailing at the destination a certain number of days after the oil was lifted.

Let us take as an example heavy Saudi crude (27˚ API), which is the main marginal Saudi crude available these days. Should a refiner intend to take a 2-mn-barrel cargo of this oil to the United States in a vessel supplied by the lifter, the price he will eventually have to pay for the oil is a ten-day average of the WTI price obtaining in the market 50 days after the date of the bill of lading minus a pre-announced (by Saudi Aramco) price discount (because Saudi heavy crude is of inferior quality) applicable to the month in which the oil is lifted.

A cargo of Saudi heavy crude lifted, say, on the 10th of September 2007 from Saudi Arabia’s Ras Tanura export terminal in the Gulf, would attract a price that is an average of the prompt WTI price obtaining during the period 24th to the 29th of October ’07 minus a discount of $9.10/bbl (for all September ’07 liftings).

What the refiner would have had to consider prior to lifting is whether the $9.10/bbl discount offered on Saudi heavy crude loading in September is sufficiently attractive to make lifting such a cargo profitable on being refined in the US Gulf region 50 days later.

Naturally, the greater the discount against WTI the more advantageous it is for a refiner to lift a cargo destined for the US Gulf and vice versa the smaller the discount.

On this basis, we would expect to observe a positive correlation between Saudi Arabia’s oil production and the discounts offered by Saudi Aramco on the price of its heavy oil. As it happens, the correlation between these two variables from Jan ’06 to Sep ’07 was 76%, which is reasonably high, as a visual inspection of Figure 2 shows.

Refiners tend to treat Saudi heavy as the ‘swing’ crude, putting more of this type of oil through simple refining processes if the value of the product mix that emerges (the Gross Product Worth, or GPW) more than covers the cost of the crude.

Lower discounts on heavy crude reduce the attractiveness of the marginal Saudi barrel — ceteris paribus — leading to lower oil exports and lower oil production. During the period considered, the discount offered on Saudi heavy crude destined for the US Gulf dropped from $14/bbl (Jan ’06) to a low of $6/bbl (in May ’07); unsurprisingly, over the same period Saudi crude oil production declined from almost 9.6 mbpd in Jan ’06 to lows of 8.53 mbpd and 8.58 mbpd in April ’07 and May ’07 respectively.

Since May this year the discount on Saudi heavy crude to the US Gulf has been rising, reaching $10/bbl in October ’07, and guess what? Saudi crude oil production has been increasing also, rising by an estimated 280,000 bpd between May and October ’07.

It is clear from the above that …

1. Saudi Arabia wanted to cut its production of crude from April 2006 onwards in order to reduce its oil exports and thereby boost the market price of oil.

2. The Kingdom sought to achieve this by manipulating the price discount on its heavy crude, which constitutes the marginal crude in the market and of which Saudi Arabia has ample spare production capacity.

3. Saudi Arabia has been hugely successful in its attempt to raise oil prices; for the Kingdom to claim that high oil prices are largely due to speculation or refining problems is disingenuous.

4. The Kingdom probably did not expect the OPEC basket price to exceed $75/bbl, seeking merely to attain a price nearer $60/bbl — a level deemed adequate for its finances.

That the oil price rose so high attests to the dangers inherent in manipulating output to bring about what are intended to be relatively modest changes in the price of oil.

For further insight into Saudi oil policy, subscribe to the Global Oil Insight