Understanding the Oil and Saudi Dilemma

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The Black Gold

Oil is undoubtedly the most important natural resource of the industrialized world, due to its vast functions for most technological, and manufacturing processes for many different sectors. Thus, its price plays a major role for most economies. Saudi Arabia, being blessed with such vast oil rich lands, accounted for 18.5% of total crude oil exports worldwide in 2014. It has been the most dominant player in the oil production market since the 1960’s; back then it co-created the organization of petroleum exporting countries (OPEC), a monopolistic cartel that united the five top oil producing countries –Iran, Iraq, Saudi Arabia, Kuwait, and Venezuela. OPEC exploited its power to control the market and gain supernormal profits by limiting overall supply. By 1973, OPEC has become a 12 country band accounting for two-thirds of the world’s oil production; and by 2010, 79.6% of the world’s oil reserves was under OPEC member nations. In 2014, oil came crashing down, (as figure above shows), from an overall increase in supply, with weak demand especially from the Asian markets. These  realities wreaked the oil market causing it to fall from a peak of $115 in mid 2014 to a mere $30 in 2016. This has led to financial turmoil for OPEC countries. Not only are less affluent OPEC members such as Venezuela hurt by the lower oil prices, but even rich Gulf States, including Saudi Arabia.

 

An Oil Party

Shale oil, oil found within rock fragments, was discovered in the 20th century and was seen as a gold mine of oil. However, the technologies needed to extract it was not available and was too costly when it was. In 2009, horizontal drilling, a drilling process in which the well is turned horizontally at depth, bundled with hydraulic fracturing, using pressurized water and liquids to break rock fragments to extract oil and gas, have become cost and operationally efficient to be used assuming oil levels remain above $45. This led to an ocean of investment into shale oil fields and created a new key and major player in the oil market.

 

EXCEL
Saudi(Orange-line) increased production, while oil prices(Blue-line) was plummeting.

Saudi fights back

For Saudi Arabia, oil accounted for roughly 80% of its exports and thus, the so called “Black Gold” source of revenue for the country, has turned from being its greatest feat to its greatest threat. Moreover, Saudi Arabia’s strategy towards declining oil prices have been surprising. Referring to the graph above, unlike most of the other countries, Saudi Arabia, extracts oil at a price of $8 in comparison to the world average of $40.This cost-advantage has allowed Saudi to boost production levels to further drive prices down to drive out competitors while maintaining minimal profits, however not enough to maintain a balanced budget. We can observe a simple decision tree in the chart below to better understand the decision behind the strategy.

Decision Tree Saudi
The best decision was  Saudi to not cut its production to yield                                              [Increase Price and Gain Market Share]

Is the Oil party over?

The amount of Shale Oil Rigs have decreased by 70% since 2014 but production of existing rigs have increased and thus overall, production capacity has not fallen significantly. However, R&D into oil fields have ceased to exist with many firms selling exploration lands at huge discounts. Moreover, Blackrock, the world’s largest asset management firm, has announced that if prices remain low in 2016, over 400 companies will declare bankruptcy and all other firms will have to take loans and lay off a large chunk of their workforce.  If oil companies default on their loans, banks get affected,  causing a domino effect throughout the economies of the world.

Competitors and the world have been enduring much more than Saudi and OPEC have expected. This has caused oil economies (OPEC) to use their foreign assets (figure below for Saudi’s NFA) to fund their budget deficits which for Saudi was at 15% in 2015. Other examples of large downfalls is the Russian Rubble depreciating by 70% since 2014 and Venezuela’s inflation reaching 140% in 2015.

SAUDI net foriegn assets

 

Time to diversify?

Oil-rich countries are battling to reform their countries, lowering oil dependency. Saudi Arabia is implementing policies under the new King to diversify the economy, and promote growth of the private sector. The Finance Minister Ibrahim Al Assaf stated on national television during an interview, that the ministry is willing to guarantee bank loans on small and mid-sized businesses, also known as SME’s. In response to a fearful market where banks might be hesitant to lend. By easing credit, young Saudi entrepreneurs will be able to start new businesses and grow current businesses at a faster rate than it normally would.

Furthermore, another initiative that Saudi is considering to implement is to privatize some of the government-owned entities, such as electric companies, airlines, and others. The most controversial privatization proposition, that created a thrill in markets, is the possibility that Saudi might initiate an IPO for Aramco, considered to be the most valuable company in the world, it aims to generate an excessive amount capital.

Saudi Arabia’s oil reign will definitely be marked in history as one of the major and most successful players in the oil market. However, times have changed as technological advances in clean, and renewable energy  develops, along with breakthrough in innovative oil extraction methods. Saudi Arabia must break the dependency on oil, and diversify its economy. To make it less susceptible to volatile oil prices, so it can preserve safety and stability for generations to come. 

Federal Open Market Committee Sept 2015: Report & Opinion

Due to the vast weakening of the domestic and global economic environment by the aftermath of the financial crisis, that lead to the great recession. The Fed kept interest rates at 0% for nearly a decade to cushion the hit, and increase liquidity, to ease credit markets (FRED, 2015). But low-interest rates for too long presented a dilemma for the Fed, it has not generated any upward pressure on inflation, and previous efforts from the QE bond buying program did not stimulate inflation (WSJ, 2015). The Federal Open Market Committee (FOMC) met on September 16 & 17 of 2015, and decided not to increase the interest rates, maintaining a [0,0.25] percent target range for the federal funds rate (FRB1, 2015). There are many interconnected factors that contributed to their decision. Among them was the current weakening of global demand, especially in China. The current and potential appreciation as a result of an interest rate hike would increase the demand for the US dollar, would negatively affect net exports even more and slow the growth of the economy. Another key factor is the low inflation rate, that has been below its 2% preferred measure for several years (The Economist, 2015). However, the committee claims that the recent drop in energy prices has put downward pressure on inflation, and are thus waiting for the prices to rise, and stabilize (FRB, 2015).  During the press conference held by Chairwoman Janet Yellen, the lag of the labor market’s adjustments relative to wage growth and actual unemployment rate was addressed and it was concluded that she would like see further improvements in the labor market that should generate some inflation, before raising interest rates (C-SPAN, 2015).  Since wage growth has been shy of expectations in comparison to previous post recovery periods (The Economist, 2015).  The current low rates have fueled auto sales and the commercial real estate while also contributing to the steady decline in the unemployment rate peaked 10% in 2009 to 5.1% in August 2015 (Hilsenrath, J, 2015). From a political stance, the U.S government depends on deficit spending, once interest rates increase, interest payments are going to be larger, and harder for the government to maintain a balanced budget. Hypothetically, as the presidential campaigns ends in 2016, a new president’s fulfillment of promises to their constituents to address the nation’s affairs could further increase the deficit. With higher interest rate the crowding effect from government spending will crowd out investments (Mankiw, 2012).

Prior to the FOMC, many economists and financial professionals have expressed their predictions and expectations towards the outcome of the Feds’ decision in major news sources. CNBC asserts that an interest rate increase will upset the bull market, bond yields will climb (Cox J., 2015), meaning that investors would consider investing in money market products which are more secure (Financial Times, 2015). The Economist claims that the faster the economy allows for higher rates, the better it is for the economy through the transition of the business cycle. Conversely, an increase now would pointlessly risk recovery, due to the 3.7% annualized pace in the second quarter of 2015 (The Economist, 2015). Moreover, according to Koch & MacDonald 2014, the banking industry would face interest rates risk, due to the change in net interest income. Furthermore, as bond yields rise, bond prices decline affecting holders of long-term debt securities, since bond prices and yields are negatively related (Croushore, D, 2014). Also increasing payments of free-floating instruments affected by a rate hike, subsequently resulting in major balance sheet changes. Taking the Mundell-Fleming Model into account, a monetary contraction either from the discount rate, the FOMC operations, or changing the reserve requirement would shift LM curve upwards increasing interest rates, thus leading to an increase in net capital inflow, which would lead to dollar appreciation, as a result negatively effecting net export and output, ceteris paribus (Mankiew, 2013).

The Fed is in a peculiar era of monetary theory failure (WSJ, 2015). It has not yet settled its tug-of-war between price stability (2% inflation) and full employment (FRED, 2015). According to the FRB 2015, forecasted projections induce that interest rates increases have a slight chance of occurring in 2015 and a significant chance in 2016 (FRB2, 2015). Whether or not the Fed reaches their target objectives is still in question. On the other hand, continuing with negligible interest rates will still hinder the effects of monetary policy, particularly under the likelihood of a recession.

References

When the Fed raises rates, here’s what happens. Retrieved 17 September 2015, from http://www.cnbc.com/2015/09/15/when-the-fed-raises-rates-heres-what-happens.html (Cox, J. 2015)

Money & Banking 3 + Coursemate Printed Access Card. United States: South-Western College Publishing.  (Croushore, D, 2014)

Federal Reserve Chair Janet Yellen held a news conference following the quarterly Federal Open Market Committee (FOMC) meeting on current economic projections. Retrieved 20 September 2015, from  http://www.c-span.org/video/?328132-1/federal-reserve-chair-janet-yellen-news-conference (C-SPAN, 2015)

Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents Retrieved 18 September 2015 http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20150917.pdf (FRB2, 2015)

Press Release–Federal Reserve issues FOMC statement–September 17, 2015. Retrieved 18 September 2015, from http://www.federalreserve.gov/newsevents/press/monetary/20150917a.htm (FRB1, 2015)

False start. Retrieved 18 September 2015, from http://www.economist.com/news/leaders/21664137-fed-should-wait-until-inflation-closer-target-raising-rates-false-start (The Economist, 2015)

Fed Delays Interest-Rate Liftoff. Retrieved 18 September 2015, from http://www.wsj.com/articles/fed-leaves-interest-rates-unchanged-1442512974 (Hilsenrath, J, 2015)

Bank Management. United States: Cengage Learning. (Macdonald, S., & Koch, T. W 2014).

Mankiw, G. N. Macroeconomics (8th ed.). United States: Worth Publishers Inc.,U.S. (Mankiw 2012)

Trapped by Zero. Retrieved 18 September 2015, from http://www.wsj.com/articles/trapped-by-zero-1442358927?tesla=y  (WSJ 2015)

Why is the Fed considering raising interest rates now? Retrieved from http://ig.ft.com/sites/when-rates-rise/#what-is-happening. (Financial Times 2015).

Retrieved 18 September 2015,Acquired from FRED https://research.stlouisfed.org/fred2/  (FRED, 2015)

FRED

Why is medicine expensive and should it be any different?

This post is a cooperation between two economics students, our guest of honor on this post, who raises the question of medicine is Bilal Abdul-Jawad, and yours truly. 

Pharmaceutical companies are profit-driven business that offers social benefits to the society (medicine) as well as private benefits for investors (profits). They operate like most other businesses by trying to exploit consumer surplus by acquiring monopolistic rights to make abnormal returns. They spend billions of dollars in research and development to make the highest quality of products, and protect their research by patenting the medicine they create, which prohibits acts of copying by competitors for products approximately 20 years. This grants pharmaceutical companies excessive market share power and monopolistic traits.

Also, the increasing role of government intervention in health care and the growth of insurance agencies have further led pharmaceutical companies to reach huge amount of profits at an even faster rate. Thus prompting medicine providers to take advantage of government and insurance companies obligations. The average patient could care less what the cost of his treatment would be if they knew they are covered. This brings us a bit off topic, nonetheless a matter to be pointed.

Pharmaceuticals research hundreds of different medicines but only a few make it to the market if not none at all and so that one product has to cover the costs, also known as fixed costs, of all failed research. Secondly, else than covering fixed costs, investors expect a specific rate of return to their investment and so revenues should cover costs and shareholder expectations (investors only goal is to maximize profit, not caring which industry it is in as long as it is legal).

An example would be if a company undertakes 10 different researches, each costing $100 million (total of $1 billion) and only one makes it to the market. This one medicine has to generate $1 billion to break-even, and then has to generate profits to invest in newer projects and to also be able to pay shareholders a decent return to not push them away. Lets say they aim to gain $2 billion in total, in 20 years time, that’s $100 million a year, say there are 1 million customers, then that’s $100 per customer regardless whether the medicine itself cost $1 to make or $50, this is how much needs to be charged.

Mon Vs Comp
Figure 1: P Competition represents operating at the price of costs with average returns. P monopolist is the price monopolies charge. (P monopolist – P competition) is the excess generated revenue they can make as they are the only providers of that product. The green box depicts the super profits a monopoly market can generate, the grey triangle is the (Dead weight loss), that the market suffers from a monopolist presence in the market.

This takes us to the big question, Why do pharmaceuticals operate this way?

Firstly, lets take a look back; economists agree that capitalistic ideals satisfy the needs of human nature, the need of greed, competition and power. Furthermore, incentives to invent are a must or else everyone would just lie around waiting for anyone else to do the hard work (free-rider effect). In our world, the most important incentive revolves around “making money”. Ask yourself this, if someone tells you go save the world, everyone would want to but just how much would you do, how much will you dedicate? Then ask yourself this, go save the world and I will give you a billion dollars; now by how much did your dedication amplify? The same goes for researching to create and help the world. Overall, we strive for a world that is rid of poverty and diseases but before we do so, selfish needs must be satisfied. In other words, philanthropy is much appreciated but is not and will never be enough to satisfy world demands; philanthropy is only achieved after selfish needs are satisfied. The only wealthy powers in an economy willing to help more than gaining returns is the government, which doesn’t have enough money to spend without generating from it and thus they are partially ruled out.

This takes us to our second big question, should these firms be run differently than firms in other sectors?

There is a growing debate over whether medicine should function like a business, guided, as businesses are, by concerns such as profits and customer satisfaction. Of course, for-profit businesses already permeate medicine, and those businesses are not confused about their priorities: providing high quality goods and services people want, at affordable prices. These companies know that they must do well in order to continue.

The pharmaceutical industry is heavily expected to not operate like any other business due to their social importance in maintaining human lives and quality. Expectations are one-sided though; people don’t realize that if these firms were not treated like those in other industries with high returns then why would investors, other than philanthropic acts, invest in them? Having high returns is also an incentive for competition to grow which causes a race to the top to become the most powerful and make the most returns. Without these factors, they would cease to exist…

Figure 2: This diagram shows the price needed for society, the price needed for fair-return pricing and the price monopolies charge. This is a theoretical approach as fair-return price is debated.
Figure 2: This diagram shows the price needed for society, the price needed for fair-return pricing and the price monopolies charge. This is a theoretical approach as fair-return price is debated.

It is true that regulating prices on a monopolist may in theory lower prices and produce at outputs seemingly more efficient. The absence of regulation or government intervention will further induce competitive barriers.

However, in the event that pharmaceutical industry would undergo any policy that would have to regulate its course of business other than first satisfying its investors we would probably see a shift of focus from quality control of products and innovation to political disputes, and cost obsessed industry, that would have negative impacts socially and privately. We would definitely see the rate of pharmaceutical innovation decline since such a field requires the brightest of minds and unprecedented patience, all the very costly indeed. Since fair return means that rate of return covers cost without having economic profits to satisfy investors, and socially optimal solution would only make government pay for the difference for operating at a loss. Governments would spend taxpayers’ money on creating medicine with high social returns but ideas and incentives would be lacking. Overall, it would reflect the cons of socialism, people would just do what they have to rather than be more efficient if no compensation is available. Also, governments cannot tackle all problems sufficiently at once as they are made of a group of people as well, whom are all imperfect. Some people might debate that some of the greatest inventions in many sectors were acts of brilliant people who did not expect large returns such as Einstein, Marie Curie and Max Planck, but then again, people like them still exist and do help the world for free but with the introduction of the private sectors, millions are added leading to overall better efficiency. The new Hepatitis-C cure names Sovaldi, cures Hep-C in 81 days and costs $81000. This is an insane amount, but looking at the world before this drug was invented, the average Hep-C patient would spend over $190,000 over the course of 35 years and never rid of it. Sovaldi, whilst momentarily expensive, yields results unavailable before at less than half the price.

 Private sector is needed but these explanations are not sufficient, so what should be done?

The biggest power there is on any firm is the government itself. Rather than providing 20-year patents that could, depending on product demand, yield profits way beyond what is deserved; governments could quantify the amount. An example would be that government force firms to lower prices to certain levels once profits reach a specific percentile. This weakens monopoly power and allows for further research in the field, increasing social rate of return.

OR?

We could think about these issues in a different spectrum or scope so to speak. This desperate search for solutions for rising health care costs concerns and all associated socioeconomic problems. Ponder on this, wouldn’t a huge portion of these problems be solved if people aren’t as sick and weak as they are now? Why can’t government invest in promoting good health,  provide healthy awareness campaigns, target future generations to aspire to be healthy and fit, and regulate food and beverages quality.

The Unemployment Paradox

“A man willing to work, and unable to find work, is perhaps the saddest sight that fortune’s inequality exhibits under the sun.” – Thomas Carlyle

Unemployment by definition is probably one of the main issues in any developed/developing nation with its right mind should have in its agenda in policy-making. Well think of it as this, the more people work, the more they can spend, the more they spend the more economic activity can occur and other businesses gain from this spending, and that increases their standard of living, it’s a virtuous cycle!

Unemployment however is a moody child deprived of sugar, it wants something in exchange for something else, aim for the short-run and you could hurt the long run. Enforce wages you could cause more unemployment, form unions and collective bargaining that sets wages above the equilibrium level and you could find yourself at a monopolistic labor supply.

Even at periods of high unemployment some governments issues an unemployment insurance, to help its people cope with the situation, which if a person is unemployed they get paid for the amount for some of the time they are unemployed, text books and studies have shown that long periods of unemployment insurance can cause even more unemployment. The problem and issue of unemployment can be mind-boggling, however many factors come in play and the role of government is vital.

If the goal is to substantially lower the natural rate of unemployment, policies must aim at the long-term unemployed., because these individuals account for a large amount of unemployment. Yet policies must be carefully targeted, because the long-term unemployed constitute a small minority of those who become unemployed. Most people ho become unemployed can find work within a short time. (Mankiew-Macroeconomics p190)

The graph depicts the following. (for savvy economic readers, I chose to post a typical S&D graph to help illustrate the results of price floors, rather than incorporating the wage rigidity graph)

  • The vertical Axis labeled Price, by price I mean the price of hiring labor, or think of it as salaries/wages. The Horizontal Axis labeled Quantity(In labor).
  • Supply of Labor(Red Color) shows the positive relation it has with price and as price goes up more, more people are willing to work.
  • Demand for Labor(Blue color)shows the negative relation it has with price and as price goes up, less firms are willing to hire labor.
  • The equilibrium level is the Market clearing Price & Quantity. labeled QE & (E)equilibrium price.

When governments, unions, or any institution intervene on the labor market and enforce a price floor above the Equilibrium level, which means a minimum wage, or minimum salary that is above the initial equilibrium price (Point of intersection QE&QP).This in fact does two things in the short run. The first thing it does is that it creates a (surplus) that can be shown in the graph a red inverted triangle. Quantity supplied is now greater than Quantity demanded, which means the amount of people willing to work at this price exceeds the amount firms are willing to hire at this price level. This in  fact causes an imbalance between the forces in act.

In simpler terms: Lets say you have a firm and you have a budget of $10,000/month to hire workers each month. People are willing to work for $500/month, so that means that you can hire 20 workers each month for your operation. Now suppose the government wants to create a price floor and wanted to increase wages for workers and imposed a minimum $1000/worker to help workers earn more. Your firm’s budget is still $10,000/ month, however now you can only hire 10 workers.

So 10 people are happier and another 10 are sad, its a trade-off, fair or not depends on where you stand my friend.