Abstract
The November 2014 Saudi gambit to increase oil production and drive down prices was a deliberate decision to quell the shale oil revolution. Ostensibly, that decision has been very costly to the Saudis, but the relevant question is would they find themselves worse off had they not acted. This paper presents a counterfactual analysis of that decision and finds that to have continued to cut production to sustain high prices would have been worse yet. Consequently, because of the shale revolution, future oil prices appear likely to fluctuate between a new floor and new ceiling price. A critical question then becomes what role will OPEC play in affecting prices within this new range of variation. This paper presents two contrasting views.
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Notes
For example, see Bazzi (2014).
See Goldsmith (2014).
See Goldwyn (2015).
See Evans-Pritchard (2014).
These shale formations contain high porosity of hydrocarbons but low permeability preventing the hydrocarbons from flowing to the well bore. Hydraulic fracturing, which uses large volumes of water and sand, effectively creates permeability by fracturing the tight oil/shale formations. At the same time, the combination of horizontal drilling allows the well bore to penetrate the formation horizontally, creating interaction with the shale formation over distances as long as several miles.
A superficial calculation might conclude that finding costs per barrel less are only about $14/barrel. But this overlooks the fact that these wells produce large quantities of natural gas which sells for much less than oil on a BTU basis.
We choose to adopt $100/barrel as the counterfactual price even though at the time of the November 2014 OPEC meeting, oil prices were already below $100/barrel. The rationale is that a sizeable contingent of OPEC producers were proposing output cuts in an effort to re-establish the previous trading range from 2011 to August 2014. By choosing $100/barrel as the counterfactual price instead of $80/barrel, Saudi revenues would have been 20% lower. A lower counterfactual price would imply that the Saudi decision was even less costly than at $100/barrel. Thus, by choosing $100/barrel as a counterfactual price, the analysis tends to favor the contention that the Saudi gambit was a mistake.
Interestingly, after prices plummeted to $8/barrel, order was restored in the cartel by the Saudis adopting a tit-for-tat strategy to deter cheating. See Griffin and Neilson (1994).
This was the hay-day of the peak oil theorists. At the same time, Matthew Simmons (2005) published his book, “Twilight in the Desert,” asserting that Saudi oil reserves were grossly over-stated as well.
Because this latter figure is reported in barrels of oil equivalent (converting natural gas to barrels of oil based on its BTU content), it masks the effect of drilling locations with greater liquid content. Given the relative low price of natural gas, producers likely focused on locations with greater oil content.
In an interesting paper, Smith and Lee (2017) recognize the importance of excess capacity and attempts to include these effects in his reserves analysis.
See Smith and Lee (2017).
James Sweeney (2016) illustrates their importance and provides an interesting analysis of the various sources of efficiency gains in energy conservation.
See Cunningham (2016).
Over the period 2014–2016, Iraqi production increased by 1.1 MMB/D while Iranian production increased by 0.9 MMB/D.
Potentially, some countries might join Saudi Arabia in cutting output while other members could offset these cuts by increasing output.
Smith and Lee (2017) contend that the price floor could be as low as $20/barrel. This assumption does not account for uncertainties in drilling and fracking as well as the assumption of a log-normal distribution of drilling sites.
Interestingly, Pashigian’s limit pricing model, while not intended for oil, appears directly applicable.
See Aguilera and Radetzki (2016), p.4.
Ibid, p. 77.
Ibid, p. 208.
Based on the short-run price elasticity in Griffin and Schulman (2005), a 1-MMB/D output cut could increase oil prices from $50 to $65/barrel in the absence of any cheating or supply response by non-OPEC producers. But even after allowing for these other factors, the price effects can be substantial.
Griffin and Neilson (1994) explore various game theoretic methods to deter cheating and conclude that particularly in the late 1980s that a “tit-for-tat” strategy was used with some success by the Saudis. They show that the Saudis ignored minor levels of cheating recognizing that small producers have more incentives to cheat. But the Saudis moved aggressively to punish large-scale cheating, with the result that after punishment, prices returned to higher levels.
See Griffin (2009), p. 45.
See Wingfield et al. (2017).
For a discussion, see Griffin and Xiong (1997).
For some interesting estimates for various plays, see Smith and Lee (2017).
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Acknowledgments
The author wishes to thank Michael Pollard and F. Gregory Gause as well as an anonymous referee for helpful suggestions. Shelby Ponzik and Cynthia Gause provided excellent editorial assistance.
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Griffin, J.M. The Saudi 2014 gambit: a counterfactual analysis. Miner Econ 31, 253–261 (2018). https://doi.org/10.1007/s13563-017-0134-7
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DOI: https://doi.org/10.1007/s13563-017-0134-7