Leonardo Maugeri is currently a Senior Fellow with the Geopolitics of Energy Project and the Environment and Natural Resources Program at the Harvard Kennedy School's Belfer Center for Science and International Affairs. In late January, the Harvard International Review sat down to talk about what went on behind the scenes when oil prices fell in November 2014, and how it has affected geopolitics since then.
How would you describe the reasoning of Saudi Arabia to continue producing oil at high levels?
Over a year ago, they started to consider two different scenarios for the price of Brent Crude oil: one scenario was for US$45 per barrel and the other was US$60 per barrel. I am told that for a while they did not believe that there was enough oil in the world, so sooner or later the price of oil would go up and up and up. But about one year ago, they started to study these two scenarios, and they saw that even in the case of the price of oil at US$45 per barrel, they could still manage the situation to a certain extent. Of course, we know now that this decision proved very costly because they had to drain US$10 million a month from their foreign currency reserves. At the time, however, they considered this a very unrealistic outcome, and they wanted to do something to eliminate the high cost production that exists in the world, so they had to consider the US$45 per barrel scenario.
As time went by, they realized that the increase in production would continue. The Saudis admitted that I was correct in my original analysis that this overproduction was continuing, and they were convinced at some point that at US$75 a barrel they could displace most of the US shale oil production. I warned them that they were totally wrong because according to my studies, the break-even price of shale oil in the United States is much, much lower. Finally by November 2014, they subscribed to this logic: ‘look, if we cut production, we only make a gift to the United States, Canada, and to high production countries. We have to simply help the market work and see what happens’. Consequently, they basically decided not to cut production. At the time, they were already shortening 2.5 million barrels a day of oil as spare capacity, and they decided not to cut any more. The market watched then, and the Saudis were ready to wage a war for one year, even at US$45 per barrel. Their thinking was: we will suffer, but the others will be destroyed.
Essentially, Saudi Arabia will now wage this war of prices. As long as they are a significant part of excess production, the war is eliminated. However, this will not end well this year because most of the production will rise due to the fact that companies that have already spent a large part of their budget continue spending. They are cutting—it is true that they are cutting investment—but mainly in new exploration, for natural gas and for projects in their stock up phases. They are not cutting development or already developed fields at all. Therefore, the situation of bull prices will continue.
[Saudi Arabia's] thinking was: we will suffer, but the others will be destroyed.
Not everyone in Saudi Arabia agrees with this economic strategy, but this line of thinking was approved by King Abdullah bin Abdulazi, who died on January 23, 2015, and it was the result of decisions made by the minister of oil and the minister of finance. The king had complete trust in these two ministers, and it is difficult for anyone in Saudi Arabia to say something against the king, or even against the minister of oil and the minister of finance since they are the people the king held in the highest esteem.
But what will happen to Saudi Arabia after the departure of King Abdullah? The new king, King Salman bin Abdulaziz, probably shares the same view as his predecessor. Yes, the son of the new king is number two in the ministry of oil, and in the past he has not always aligned with the current minister of oil. In fact, there have been several clashes between the two. But now there is a common understanding: the Saudis cannot stop now if they do not see the continuation of this production.
THE PLAYERS OF THE OIL GAME
Do the Saudis see US shale production as a threat to their market?
Yes, now they see it as a threat. Their first target was not Iran and it was not Russia—it was the United States. If you look at the last four years, the biggest increase in global production of shale was by the United States. For a long time, Saudis considered shale oil in the United States a temporary phenomenon, since it is such a costly option, so they were not very concerned. However, in the last year, they changed their mind. Now, they consider US shale production to be the main factor responsible for the decrease in the excess production of oil. So their major target is the United States, their secondary target is Canada, and another secondary target is Iran—though more for political reasons. The United States is definitely their main target.
How desperate is Iran right now for higher oil prices?
They are really on the verge of collapse in Iran. They are desperate for cash, and the government has decided to sell waivers for young boys to not go to their military service. So the situation in Iran is really bad. Along with Venezuela, Iran is the first to run the risk of collapse. Why do you think that the Persian Gulf nations refused to lower their production when Iran and Venezuela approached them? Saudi Arabia is convinced that it is totally useless to cut production. From their point of view, if they cut production within the Organization of Petroleum Exporting Countries (OPEC), they are only giving a gift to the United States, Canada, and Russia, countries that produce oil at their capacity and that will continue to produce oil at their capacity. If Saudi Arabia were to cut production, it would lose more; however, if it were to continue to produce oil at high levels it might suffer a little, but the other nations would suffer much more since their production is more expensive than that of Saudi Arabia.
As I mentioned previously, in November 2014 Saudi Arabia already had a spare capacity of 2.5 million barrels a day, which means that it was already cutting 2.5 million barrels a day of oil production. This leads to a second issue within OPEC: who should cut production, and by how much? In response, both Iran and Venezuela are strong advocates of Russian cuts, and I know from the internal discussion that they maintained that they could not cut that much. Iran already has international sanctions, and they are already cutting one million barrels per day of oil because of those sanctions, so from their perspective, they do not have much room for cutting production. Similarly, Venezuela is already producing much less than it could. Saudi Arabia knew very well that everyone in the offering domain was looking at Saudi Arabia to cut more of their production, but this of course was not sustainable for Saudi Arabia. That is the reason why in addition to all of the political considerations, there was no economic reason for Saudi Arabia to cut production.
Can you expand more on the political reasons?
Saudi Arabia is very preoccupied with the current state of negotiations between Iran and the international group—in particular the United States—about the nuclear issue. Saudi Arabia is very worried that at some point the United States may make concessions to Iran and that Iran might be recognized as a regional power. So while the main target behind their strategy was really to try to eliminate excess production, specifically the production of the United States, Saudi Arabia’s choice to leave the market also allows them to weaken Iran during a very delicate phase of negotiations. Of course, this was a very important political corollary to their economic strategy because Saudi Arabia does not want anyone to give Iran any regional significance or regional power.
What do you see as the status of Russia’s economy in the near future?
Russia is another country that is in a very difficult situation. 52 percent of its government’s revenue depends on oil and natural gas, and with the two so closely related in terms of price, every one dollar in the price of oil translates to US$1.7 billion in revenue for the Russian government. This means that if Russia faces low prices like this for the whole year, it will lose more than US$70 billion of revenue out of their budget of around US$300 billion, so there is a huge amount of money at stake. All the fortune of President Vladamir Putin since he took office has stemmed from the increasing price of oil, and thus the price of natural gas as well. This has been the story of Russia and its leaders for the last 40 years—their fortunes and misfortunes are dependent on the price of oil. The great luck of Putin was to experience a long period of increasing prices of oil, but now he is facing a totally different reality. It is still uncertain what will happen to Russia, but it is a very delicate issue. That being said, we can already see that Russia is in a very bad situation socially: in response to the falling oil prices, Putin is mounting a big propaganda campaign and increasing repression, internally spreading the idea that the decrease in oil price is a conspiracy between Saudi Arabia and the United States in order to attack Russia.
How long do you think the oil price will stay low?
Oil prices will stay low for at least this year, and then we will have to see what will happens. We also know that there is another problem: demand for oil in the world is not rebounding significantly.
There are reasons other than pure economics. The lack of a rebound is not only due to the uncertain economic situations of different areas of the world, but also the legislation of governments on energy efficiency, environment, and climate change, which has been approved across the world—even in China and many other countries—that is in a way putting a brake on the possibility for oil demand to rebound. Consequently, it is not only an issue of supply, it is also an issue of man.
In 2012, when I made my analysis for Harvard about the possibility of an oil price collapse, I said that the key year would probably be 2015. It was a very easy conclusion to come to because I looked into the investment of all the projects and oil fields. If you approached the issue with a bottom up approach like I did, instead of the typical approach used by the Energy Information Administration of the International Energy—a top down approach based on econometric models—it was very clear that there was a mounting wave of production capacity. It was not mentioned back then. Now, the issue is much more complicated because we have to see what will be the real effect of investments, for example, of several companies and countries on this collapse of oil prices. Still today, investment cuts announced by many oil companies and countries are not enough at all to eliminate the oil production that already exists and the one that is in the pipeline. We are in a dynamic situation, and as things stand now, I say for this year at least, the price of oil will remain quite low, experiencing some volatility upward—let us say toward US$65 to US$70 for Brent Crude—just to return to where it was.