Thinking about strategy requires assessing one’s role in the overall market. For Saudi Arabia, that’s not what it used to be. While their output of crude oil in 2013 at 9.9 mil bbl / day is about what it was in 1980 (and is just shy of the peak over the period 1980-2013), their market share is distinctly lower, falling from 17% (of global output of 59.4 mil bbl/day) to under 13% (of 75.2 mil bbl/day). That limits their pricing power.
Elasticities tell the story. The short-term price elasticity of demand is about -0.2, the medium-term one of course is more elastic at -0.5 or greater. [In most energy markets the income elasticity of demand is roughly 1.] So if the Saudis cut output by 10%, global output falls about 1%. That means prices rise 5%. Unfortunately for the Saudis that means their income would fall by 5%. With a population burgeoning in numbers and expectations, and as the ideological seat of the Wahhabi sect that fuels radical Islam but so far has not seen cause to bite the hand that feeds them, they can’t afford a large hit.
Now if OPEC (or at least the Middle East subset) was a true cartel, the Saudis could count on others cutting back as well. That changes the arithmetic in favor of cutting output. But Iraq needs to pump every barrel they can, and Libya and Iran as well. Such lack of discipline is reflected in the history of OPEC: in the past, whenever prices were low, attempts by the Saudis to drive up prices were offset by rampant cheating by other OPEC members. There’s no reason to think today would be different. But in the past the Saudis were big enough to go it alone; today they’re not.
One other bit of economic logic reinforces this argument: when interest rates are low and prices are low, it makes sense to leave oil in the ground rather than to pump and sell it. Selling turns oil into bank deposits, and those earn nothing. Leaving oil in the ground also provides the option tot benefit from future price rises [though the option loses its value if prices fall further]. So do you want to store your oil in the ground, or store your oil in the bank? (Those with finance acumen can do the corresponding net present value calculation, and maybe even put a valuation on the option.)
In sum, we should be highly skeptical of the claim that the Saudis are pumping a lot of oil to try to drive new producers (particularly US frackers) out of business. If nothing else, there’s no reason such producers won’t jump back in with higher prices. Chapter 11 bankruptcy hurts creditors but leaves the underlying business in place, and the distribution pipelines will remain as well. Low prices may curtail additional drilling today, but that’s scant help to Saudis in keeping prices high tomorrow and the day after. In other words, basic economics indicates we don’t have to resort to nefarious, anti-American conspiracies to explain Saudi behavior.
This term we will play with many concepts, including market power and cartel stability. We’ll use examples from the iron & steel industry and the beer industry on a regular basis. But if you delve into details, you’ll find that product differentiation matters in petroleum markets (not all “crude” is alike). That limits the options further for producers of undesirable (heavy, sour) crude.