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. 

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.