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. 

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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.

Short term effect on the average consumer as oil prices drop. (Theoretical approach)

Most economists agree that Oil is considered to be a normal good, by normal we mean that as your income goes up you would buy more of that good, that is a basic definition. As  oil prices fall you would expect that oil consumption would increase, however in the short-run that is not the case. Oil in fact is inelastic in the short run, inelastic means that its consumption is not sensitive to price. Companies still need to operate at the same rate to satisfy their operations and people still need to drive to get to work. It takes time for markets to adjust and people to change their way of living. The long run is a different topic by itself and is out of the scope of this post. You are not going to buy a 8 cylinder pick up after you hear oil fell this month are you?

We can then agree that oil consumption would not change in the short run. Now we can check the graph that I have made to illustrate a theoretical approach of what consumers are going through at this point of time.

Lets say that you pay $500 rent a month for 5 years. Suddenly rent became $300, means you have $200 more to spend on other things other than rent or you could decide to save it. So in simple terms lower oil prices has caused income to increase, which means people can consume or save more than they previously could.

Check below for technical details on how I reached this conclusion using Consumer behavior theory.

The graph you see is the consumer theory diagram.

First be noted of the following.
  • The Vertical Axis labeled “A.O.G”(All Other Goods)- In terms of Quantity. (The farther up means more)
  • The Horizontal Axis labeled “Oil”.- In terms of Quantity (Further right is more)
  • The red line depicts a budget. Where “I” is the starting point. The Horizontal intercept of the Budget at I & I*, to be known as (Income/Price of Oil). The Vertical Intercept is unchanged since their prices are presumed to be constant,Ceteris Paribus.
  • U-shaped curve depicts the indifference curve.
  • The green dotted line is Hicksion line, a line parallel to the new Budget line and tangent to the old Indifference curve.

A decrease  in the price of oil would shift the Horizontal-intercept on the Oil axis to the right, meaning that “Income has risen”, as indicated  I —> I*, where I*>I. Using the Hicksion method we find that initial change for the substitution effect, for as Income goes up we would have to consume more, for the normal good condition. Moving oil Consumption from X*—>X and shown on the original indifference curve Point (A) to point (C). Since we have established that oil is inelastic in the short run, so that would mean that consumption levels of Oil would go back to its initial starting level X* but on the new Indifference curve on the new budget line resulting in tangency of Point (B), which satisfies the inelastic condition, where consumption for oil does not change. However that results in A.O.G consumption  increase from Y —> Y1. Which satisfies that a drop in oil prices in the short run leads consumers to spend more on other goods, Ceteris Paribus.


In summary

A—->C = Substitution Effect

C—->B = Income Effect

A—->B= Total Effect