Saudi Holiday Gift: Buy One Barrel, Get One Free

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Includes: BNO, CRUD, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI, XLE
by: Andrew Hecht

Summary

Oil is a political commodity - a chess game.

Saudi Arabia controls OPEC.

Winners and losers.

Lost revenues in the short term a small price for the Saudis to pay.

Two commodities have a long and storied political history: wheat and crude oil. Bread is a staple all over the world. Rising wheat prices have been responsible for revolutions throughout the pages of history. Many believe that the Arab spring in 2011 began as the result of bread riots in Tunisia and Egypt. Crude oil has also had a storied history, perhaps more recent due to the increasing demand for crude oil in modern society. Gasoline lines in the late 1970s resulted from the Iranian revolution. There are so many examples. In 2014, crude oil has moved lower with a vengeance.

In all commodity markets, supply and demand ultimately determine price. Production of commodities is generally in regions where they exist in the crust of the earth or the climate suits production. Chile produces copper, because it has huge reserves. The Ivory Coast and Ghana produce cocoa beans because the equatorial climate makes production possible. Wheat grows in countries where weather and soil favor the grain. Oil production in the Middle East, Russia, the US and a number of countries around the world depends on the cost of extraction. Consumption of most commodities or the demand side of the equation is ubiquitous. As global population increases, the addressable market for raw materials grows. Lower oil prices in a world filled with turmoil presents problems and opportunities. Over the past six months, a re-pricing of this commodity has wrecked havoc in some countries and created opportunity in others.

Oil is a political commodity - a chess game

When Saddam Hussein invaded and attempted to conquer Kuwait in 1991, it was because of one reason. Kuwait is a tiny nation; the population is less than 3 million people. Kuwait is rich and it is wealthy because this very little Middle Eastern country is the tenth-largest producer of crude oil in the world. Saddam knew that if he could control Kuwait, it would vault his position within OPEC, the oil cartel, and on the world stage. For Hussein, oil was power - and today oil remains a political tool that countries use to further their standing in the world.

When a commodity becomes a political tool, the motive for actions of major producers must be considered - and not just for economic reasons. A high price for a commodity will benefit a producer but high prices naturally encourage more production. More production outside of traditional output regions will reduce market share for those lower cost extractors of the commodity. What we are witnessing now is not a price war so much as a power play, and that power play has everything to do with market share.

Oil is a political tool. Many have opined that the recent OPEC decision to leave production levels unchanged was to destroy the economics of the commodity for higher-cost producers, particularly those in North America. However, that is a simplistic view of the situation. It is far more productive to look at the fallout and work backwards to discover the true intentions of the players in the world of crude oil.

Saudi Arabia controls OPEC

The recent OPEC meeting and the decision to leave production levels unchanged, regardless of price, has demonstrated the strength of one of the world's top two and its lowest cost producers. During the meeting in late November, the Saudi oil minister stated that the market would find a fair price for oil. The Saudis stated that market share is what is important to them. In the wake of the meeting and as crude oil prices cascaded lower, the Saudis have held firm.

Many other OPEC members did not agree. Poorer oil producing nations like Nigeria, Venezuela, Algeria and others argued for production cuts. The Russians, who are also a top two producer of crude in the world, met with their co-leader prior to the cartel's official session. Russian influence to cut production went in one ear and out the other; Saudi Arabia had a plan and they executed it in brilliant fashion.

The Saudis walked out of the OPEC meeting affirming their dominant position within the cartel and as the world's leader in the production of crude oil. That position is one of control.

Winners

Clearly, the Saudis are a winner. Now the oil-rich Kingdom is firmly in control. Lower oil prices will curtail oil production in the United States, however, the net effect is positive, as the US is a giant consumer of oil. Fed Chairman Yellen said so much in her press conference following the recent Federal Reserve meeting this past week. Gasoline prices at the pump have plummeted along with heating oil prices as the US enters the winter season. Corporations have seen energy expenses cut, drastically. Lower energy prices amount to a tax cut for non-energy producing corporations and US citizens. More money in the pockets of US citizens will likely increase spending, thus helping the economy to continue to recover and thrive. The US stock market, for now, has rallied however, we will have to wait and see if stock prices stay buoyant if the price of crude oil continues to fall. January action will tell the tale.

China and Asia are big winners. The Chinese economy has been sluggish in 2014 - the country has not met growth expectations. The Chinese, as well as other Asian nations, are huge oil consumers. Lower oil prices could be just the stimulus these nations need going into 2015.

Losers

The world is all about balance, not everyone can be a winner. Lower oil prices are creating difficult conditions in areas of the world. The biggest losers are Russia and Iran. Both countries are under sanctions for a variety of reasons. Lower oil revenues will bite both countries in a way that directly and quickly affects their populations.

Economic hardship experienced by Russians and Iranians could be to the benefit of the Saudi Kingdom. Iran has a long history of supporting radical Islamic elements who would like nothing more than to unseat the Saudi Royal Family and take control of the country that has so many important religious sites within its borders. Additionally, deteriorating economic conditions continue to put enormous pressure on the Iranians to come to terms on nuclear nonproliferation. A nuclear Iran is not in the best interest of the authorities in the Saudi Kingdom.

Russian oil production has grown in recent years. While not a member of OPEC, Russia has become the largest producer and exporter of crude oil in the world. Economic hardship in Russia, a plummeting ruble and instability benefits the Saudis with respect to market share. The Russian leader, Mr. Putin, has displayed an aggressive style. His close relationship with Iran clearly is of concern to the Saudis given that a combination of Russian and Iranian crude production will exceed Saudi output by some 50%, thus jeopardizing Saudi control.

Lower oil prices therefore make sense, not only from the point of view of market share for the leader of OPEC but also from the political position that conveys.

A small price to pay

Lower crude oil prices will cost the Saudis some revenue in the short run, but it is a small price to pay. There is a clear alignment of Saudi policy, particularly with respect to Iran and Russia, with that of the country's number one ally and supporter in the world, the United States. US energy independence could fall by the wayside given lower production due to lower oil prices. A lot of US oil production is high cost. However, that private production will fall by the wayside - a victim of capitalist Darwinism. Like the Saudis, it is a small price to pay for the US. The use of crude oil as a political tool is perhaps more important than revenue flows and immediate gratification.

Saudi policy has given consumers around the world a holiday gift. Based on where oil prices were just six months ago, it is a case of buy one barrel, get one free now. For the US, it could be a gift that keeps on giving - if it weakens enemies of freedom. Saudi control comes with responsibility - perhaps their stance is to weaken those who pose an ultimate threat that transcends economics. Remember, when it comes to crude oil, price action can often reflect the political rather than economic goals of the dominant players in the great chess game of geopolitical influence. In this case, the greatest future reward for Saudi Arabia may come from giving.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.