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Why is Crude Oil Overpriced?

Commodities / Crude Oil Nov 18, 2013 - 03:39 PM GMT

By: Andrew_McKillop

Commodities

POLITICAL RISK VERSUS ENERGY ECONOMICS
Expressed in terms of price for 1 barrel equivalent of oil energy at present market prices, world coal costs about $14.50 per barrel FOB (before transport costs), US domestic natural gas costs about $20.50 per barrel, while European and Asian natural gas is priced at more than $65 per barrel, but will surely and certainly decline in the next 3 – 4 years.


Present mid-November oil prices are around $94 per barrel in the US for benchmark WTI, and $108 per barrel in Europe and Asia for benchmark Brent. No petroleum resource, production, or oil transport logistics factor can explain this differential.

The oil risk premium atributed to Middle East and North African civil tension, rebellion, terrorism and war is set by traders and analysts and partly explains the Brent premium against WTI, due to Brent-grade oil being the "eastern hemisphere benchmark". This premium is about $14 at present. This excludes what we can call the energy economic premium.  As we can see from world energy prices, above, oil commands a massive global energy economic premium, as well as the regional political risk premium. When analyzing the renewables and depending on type, although they often have high capital costs many have marginal "fuel" costs of zero. Already today, oil-fired electric power generation is totally uneconomic, worldwide, and gas-fired power is uneconomic in Europe.

The energy economic premium for oil is at least $30 per barrel equivalent of energy, meaning that priced at its strict energy economic value, the oil price is around $65 - $70 per barrel under current global economic and energy economic conditions, on top of which an "energy rent" is added. Removing the geopolitical risk premium of approxinately $14 per barrel would of course reduce the "rational efficient" price of oil even further. The actual production costs of oil in different regions, using different technologies would then dominate in price-setting, but at present this factor only has a marginal price-setting role. On a very approximate basis, actual production costs of oil are rarely above $55 - $65 per barrel in the highest-cost regions using the highest-cost technology.

KING COAL - SAUDI PRINCE OIL
To be sure, oil's huge energy economic premium is rarely focused by either mass media or financial analysts but obsessive attention goes to oil's geopolitical risk premium. This almost exclusively concerns Middle Eastern and North African (MENA region) political turmoil, and potential threats to oil production and oil transport, as well as (mostly potential) politically-motivated witholding of supplies or extreme pricing demands by regional producers.

The local players are dominated by Saudi Arabia. With Russia and the US, KSA is among the Top 3 world oil producers. Its basic advantage relative to Russia and the US is low or very low production costs although these are rising. The Saudi role with other OAPEC (Arab OPEC) producers, and OPEC producers including Iran at the time of the first Oil Shock, 1973-74, where there was initial total producer consensus that oil was radically undepriced, soon shifted to KSA playing a so-called "moderating role" in global oil pricing.

Especially in the period 1985-88, Saudi Arabia acted to depress oil prices in order to weaken or inflict economic damage on the Iranians during the 1980-88 Iran-Iraq war, in which Saddam Hussein's Iraq was politically and less surely economically backed by the Sunni-ruled Gulf principalities including KSA. During 1990-91 KSA again played a role to limit oil prices rises, by raising production, but this time in response to fellow-Sunnite Iraq's invasion of Kuwait, probably with the aim of limiting damage to Sunnite political hegemony in the Arabian peninsula.

It can however be argued that throughout the long period (1986-99) of either low or very low oil prices, Saudi Arabian "oil pricing hegemony" inside OAPEC and OPEC was "price moderating" at nearly all times. It can be argued for example that KSA's role as "swing producer" and the linked oil pricing strategy – to either force prices to fall or recover by acting as swing producer, raising or lowering output by huge amounts – was and is more apparent than real. As one example, at the start of the 1986-99 long period of low prices, KSA quickly abandoned its "price defending" role of massively cutting its oil production. For a short while, KSA cut output to less than 3 million barrels a day, but soon returned to "revenue maximising", albeit at low barrel prices, by raising output to well over 8 Mbd which it then maintained throughout the long period of cheap oil.

Although the famous "broken promise" of US president Franklin D. Roosevelt, in his April 5, 1945 letter to King Saud of KSA, following their February 1945 meeting on the USS Quincy, is mainly featured in analyses of US-KSA political relations, their oil relations also discussed aboard the destroyer Quincy were simpler, if confidential. At the time, the US was the world's biggest producer and exporter of oil. Saudi Arabian resources were however already known to be massive and cheap to produce. US oil corporations and those of its Allies were intent on raising Saudi production – evidently with a downward impact on prices, compensated for them by much greater production of the low-cost Saudi reserves - as well as the very low cost reserves of several other future member countries of OAPEC and OPEC, including Iran and Venezuela.

Oil energy was already cheap, and would become cheaper.

With sure and certain US-KSA agreement on pricing, oil prices were held at about $12 - $15 per barrel (in dollars of 2012 value) through the long period of about 1950-73. This “oil price ceiling” would not have been possible without US and Saudi agreement. At these oil energy price levels, neither coal energy nor natural gas energy were able to have any large price advantage. Also due to technical and environmental reasons, this accelerated the decline of coal in world energy, to its present day rank of almost equal with oil, each supplying about 30% of world total primary commercial energy. We can note that while the role of oil in world energy has been declining for over 30 years, coal's role has been growing since 2000, simply because it is so cheap. The radical growth of the world car industry, air transport, and ocean shipping, especially through 1945-75 for car transport can be closely linked with fast-growing supplies of low priced oil.

OIL GEOPOLITICS AND PROXY WAR 

Beyond the economic arena exclusively focused on oil, and as shown by the “broken political promises” of Roosevelt, the US and Saudi Arabia have at least as many times battled each other, through proxies, as cooperated. Oil also featured, sometimes directly as a war-motive or rationale in numerous US-USSR proxy wars or conflicts, for example Angola (sometimes called the 'Angola civil war, of 1975-2002). Several theaters of World War II warfare can be linked with access to and control over oil resources and production capacities.

Arenas for US-KSA conflict, as well as collusion in proxy war action have included Palestine, Yemen, Iraq, Afghanistan, Lebanon, Syria, Libya, Egypt, Sudan, Somalia and elsewhere. The very special role of Saudi-Iranian conflict, both ethnic and political, economic and religious, has offered recurring opportunities to the US, and its Allies, to play one against the other. KSA versus Iran.

To be sure this has been almost exclusively proxy warfare. Also, it has had either low or very low impacts on oil supply and pricing – in fact and concerning Iran, US-KSA collusion has mainly resulted in lower oil prices, through the episodic Saudi strategy of “outproducing Iran”.

Much more important in energy economic terms, for reasons including financialized commodity markets and trading, and asset value creation, oil is starkly overpriced today as it was in the period of 1974-85. Similar to that period, the energy economic price premium for oil is not sustainable. Given the extreme overpricing of oil today, and the recently-rising bellicosity of KSA, the existing global energy policy trend away from oil is very likely to continue, while cumulative investment-development spending on oil resources and production capacity, driven by high prices, will continue raising output capacity. Despite KSA, therefore, we can forecast generally falling oil prices.

The possibly exaggerated, but impossible to discard potential for Middle Eastern war featuring Israel, KSA and Iran – with a high possibility of such conflict, if it started, “going nuclear” - would very certainly destroy price stability for oil, even at current overpriced levels. Nuclear armed attack on Iran by either KSA using proxies, or directly by Israel would almost certainly lead to a massive drop in world oil supplies, not able to be accommodated by the price mechanism. Physical rationing of oil would be a potential result.

US DISENGAGEMENT

Recent moves by the US concerning Egypt, Libya, Syria and Iran are very easy to link with the rapid growth of US oil and gas production. Data from the Energy Department shows that in October, for the first time since 1995, domestic production outstripped imports — 7.7 million barrels a day against 7.6 Mbd. Analysts forecast that within 12 months, crude oil production will likely grow to 8.9 Mbd, while crude oil imports will drop to 5.8 Mbd. US import dependence may completely end by 2020 on current trends and was historically focussed on OAPEC (and OPEC) suppliers in the period of about 1985-2005, during which oil prices were either relatively low or very low. High oil prices have definitely spurred US domestic oil production. As shown by US shale gas production, this has grown so radically that US domestic natural gas prices, in real terms, are now historically low and the US will soon have a considerable export surplus of gas.

This surely creates a number of probable and potential arenas for US-Saudi economic conflict. For example concerning US gas exports as LNG, this runs against Saudi, Qatari and other Gulf gas producers, as well as Iran and Azerbaijan, who would seek semi-exclusive access to the high-priced gas markets of Europe and Asia, with only Russian competition. Adding US competition, as well as very fast growing LNG export offer from the so-called “new producers”, worldwide, the gas rent or gas price premium on exports to Europe and Asia is sure and certain to decline.

The potential decline in world export gas prices by 2017 may be as high as 33% according to the IEA, and could in fact easily exceed 33%. With cheap or extremely cheap gas available, this clean-burning fuel may be more widely used to substitute and replace oil, especially in land transport and ocean shipping, and space heating.

The coming decline of world gas prices and cheap coal, as well as rising output from renewables, will at some stage or another depress oil prices. When this also happens to oil, and its price premium against coal and gas declines, the Saudi ability to utilise “oil blackmail” will certainly be constrained by decreased oil prices and increasing global oil supply from more diverse sources, as well as the continuing retreat and decline of oil in world energy. Under this outlook, Saudi Arabia will be deprived of the option to “underproduce” or withold oil, as it has only very briefly done, only under exceptionally-favorable conditions for the success of this politicized strategy, during the 12 months of the 1973-74 Oil Shock.

US engagement in the MENA region can therefore decline both for political and for energy economic reasons. Inside the region, KSA-Iran conflict may itself wind down for a number of reasons, including the decline of the energy economic oil price premium, the local oil rent (due to the region's low cost production capacity) and the linked decline of oil revenues. Conversely, short-term conflict risk is high or even very high, due to the additional destabilizing threat of Israel-Iran war, currently only threatened by Israel although actively supported by KSA, if not publicly. The already active KSA-Iranian proxy warfare inside Iraq, sometimes called “the car bomb war”, and the Saudi proxy war in Syria opposing the Iran-allied al Assad Alawite regime, shows that Saudi petrodollar wealth is sufficient to support at least two war fronts.  However, potential or possible direct nuclear attack against Iran by KSA, using Pakistani-supplied weapons is now a theoretical option, although we can doubt if KSA will step outside its customary role of “proxy fighting”, using other forces to fight its wars. With a decline in oil revenues, Saudi bellicosity can likely taper down, possibly rapidly.

The entire MENA region, certainly including KSA, and Iran outside the MENA if it is considered a West Asian power like Pakistan, is confronted by large and rising economic and social challenges. As just one example, KSA and a string of other regional countries are totally dependent on food imports due to their neglected agricultural and water resource sectors, and like Europe's PIIGS have a “lost generation” of youth, with youth unemployment rates of twenty-five to forty-five percent, sometimes more. Especially in the MENA, including KSA and Iran, since 2011 this neglect of basic economic issues is a proven and potent source of social unrest. Overthrow of both regimes – Tehran and Riyadh – by street protest is far from impossible.

US disengagement in Egypt has been spectacularly rapid – in part because Egypt is now in permanent transition despite Saudi attempts to "stop the revolution" by directly supporting a military coup. Another reason is that the role and importance of the Suez Canal (and the more recent Sumed pipeline) in world oil is now vastly smaller than the Canal was in 1956. The oil-geopolitics of the region have changed. After depending on the US for over 65 years, the American "protector or vigilante" is no longer a regional power and reliable ally – or a permanent foe. This has already profoundly affected Israel, in the short run increasing its stridency and bellicosity.

LIVING WITH LOWER OIL PRICES

Looming in the not too distant future, because technological and hydrocarbon resource E&P improvements have drastically increased world recoverable gas and oil resources, as well as coal resources, oil producer countries such as KSA face the theoretical challenge of restricting Middle Eastern and North African supplies, to compensate for increased world production and "defend prices". Given that as already mentioned, the long term trend of oil's role in world energy is declining, but supply is increasing, this will be a major challenge for KSA. We can already conclude it is unlikely to effectively and durably hold down production to hold up prices.

King Abdullah has colorfully called for "beheading the Iranian snake", and KSA war drum beating is at fever intensity, like Israeli war drum beating, but the nuclear strategic threat of Iran is basically similar to that of any other country with large numbers of nuclear facilities and installations. These are able to produce either "clean" or "dirty" bombs quite fast, but also render the national security of the country an illusion, due to offering massive and dangerous "soft targets" for enemy attack.

The argument of some analysts, that KSA is seeking complete regional hegemony and the physical elimination of Iran in order to obtain total control over the production and price of oil in the Middle East, possibly also the MENA, can easily be dismissed as an impossible fantasy. This fantasy could or might be nurtured by some Saudi dreamers, to be sure, but does not resist daylight. Saudi fear and hatred of Iran, it is was so intense, would have motivated and resulted in easily identifiable and coherent use of the "Saudi oil weapon", long before today.

However, the intensity of Saudi anti-Iranian propaganda and political action, extending to its recent refusal to address the UN General Assembly and rejection of a temporary seat in the Security Council, almost surely indicates that in fact, KSA oil production and price influence – which cannot be called hegegomy – is declining. Saudi action to thwart a peaceful end to Iranian nuclear sanctions, with France and Israel, can be read as spurred by the justifiable fear in Riyadh that the end to sactions will be followed by a relatively rapid increase in Iranian oil export supplies – and a further erosion of oil prices. The reasons why France and Israel would want to pay more for their oil imports, or even face physical rationing of oil if nuclear attack on Iran is "too successful" can be attributed to "realpolitik" and do not have to be examined!

Riyadh's diplomatic theatrics are usually read as Saudi rage that Iran has "hoodwinked and deceived" an eager to be deceived and increasingly isolationist United States. The uncomfortable Saudi total dependence on oil export revenues (92% of the national budget in 2012), due to decades of under-spending outside the oil sector, and royal misspending, is however recognized by some of its princely elite as a real and urgent challenge, such as prince Alaweed. Saudi bellicosity may therefore also be read as a power conflict inside the ruling elite – where the hardliners, acting dramatically and theatrically, hope to lever themselves more power. However, because their capacity to halt the coming oil price decline is zero, as is their real ability to control the region, they will be forced to give way to reason.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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