The Saudis Are Losing Their Leverage over Oil Prices

If you had any doubt about the ongoing volatility in oil prices, the past several trading sessions are a clear reminder the dust hasn't settled yet.

After jumping more than 19% in four sessions, West Texas Intermediate (WTI), the benchmark in New York, fell almost 8.3% Wednesday, closing under $50 a barrel. Meanwhile, Brent dropped 4.4% to $54.47 a barrel after posting a similar 17.6% gain.

Then yesterday crude oil prices reversed course and rose again, with WTI gaining 4.5% and Brent nearly 5%.

Of course, Brent ordinarily trades a bit higher than WTI, reflecting the "spread" between the two that has favored the London benchmark in all but a few trading sessions since mid-August 2010.

There are two reasons for this.

First, Brent is used as the standard price for more international oil sales than WTI, making it the more commonly used yardstick.

oil prices Second, the London market is more immediately influenced by global events. Being more sensitive to geopolitical changes, Brent is more likely to spike in response to a crisis, so it typically demands a higher price.

The primary factor in all of this has been the supply. Unlike the situation in earlier price declines, demand is holding up quite well and even beginning to inch up.

Supply, on other hand, is quite another matter....

Oil Prices: How the Supply Dynamics Have Changed

Over time, there have been two major changes on the supply front that have changed the dynamics of the "traditional" OPEC-driven market.

Russia took the lead in global crude exports, and massive unconventional (shale and tight) oil reserves completely changed the production picture in the United States. So to protect their market share, the Saudis decided to fight back.

And in stark contrast to what they did previously in similar situations, the Saudis pressured OPEC not to cut production, creating an even bigger glut. Instead, Riyadh decided they would tolerate lower oil prices, while the market readjusted more in their favor.

That marked a decided break from their normal operations.

In the past, OPEC has adjusted its spigots to redress either a jump in non-OPEC supply (translating into an OPEC cut in exports) or falling non-OPEC supply (resulting in an increase in OPEC sales).

In doing so, the cartel has been able to hold sway over the price of oil. In fact, here's how OPEC usually establishes its monthly policy.

First, they estimate the global demand. Then, they estimate what is likely to be met from non- OPEC sources. Finally, after subtracting the non-OPEC supply from the projected demand, they arrive at what is referred to as "the call on OPEC."

This "call" becomes the monthly export target for the organization and is divided into quotas for each member nation. This is how OPEC has managed to control the international market.

Since it only controls 40% of global production, the cartel doesn't directly dictate the price. It simply provides the balance on the supply side, heavily influencing the price of oil.

OPEC's Fading Leverage

But the Saudis have been reading the writing on the wall for some time now.

Today, Russian crude has become a major competitor in Asia. Moscow has completed the East Siberia Pacific Ocean (ESPO) export pipeline and now plans to send a better grade of crude at a lower price than the Saudis can deliver.

That's crucial, since Asia will be the key battleground in energy for the next 20 years. And for years now the Saudis have profited off the "Asian premium" they created simply by charging Asian customers more than their Western counterparts.

However, the Achilles heel for Russian exports has always been the price, since the national budget essentially depends on sales of $80 to $85 a barrel (against which Russian exports must be sold at discount). Oil prices falling to around $50 a barrel has decimated Moscow's central planning and caused the value of the ruble to plummet.

As a result, Russian production plans are being scaled back. So score one for the Saudis.

Yet OPEC's second target is far more decisive to their strategy.

Here's why.

The advent of unconventional oil in the United States has fundamentally changed the energy world. Despite having to import almost 70% of its daily crude needs only a few years ago, the American market is now looking to become energy independent in as little as 10 years.

By 2025, the United States will still require about 30% of its oil from imports, but all of that could easily be transported from Canada (even without the Keystone XL pipeline). In fact, domestic U.S. production is reaching levels never seen before, surpassing 9 million barrels a day - within a million barrels of Saudi production.

This is the real challenge to the Saudis, even more so if current prohibitions on U.S. oil exports are lifted.

What's more, with 86% of the recoverable unconventional supply located outside North America, the battle with American shale is a dry run for the problems OPEC is about to face globally. That's what's really driving the Saudis.

In what amounts to an oil market version of a game of chicken, Saudi policymakers are trying to make U.S. producers blink first.

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And it's starting to work.

Rigs are being brought off line in numbers not seen in over a decade, while plans for more expensive drilling projects are being shelved in favor of less expensive alternatives. This is going to have an impact on the supply side in rather short order.

What is extraordinary is how quickly this has transpired. By this summer, oil prices may be back to a range of $65 to $70 a barrel. Meanwhile, some of the more knowledgeable analysts are pegging a price in the $80s by the end of the year.

In a short period of time, the Saudis have succeeded in prompting production cutbacks in both Russia and the United States. But it has come at a cost Riyadh had not anticipated.

By forcing American producers to pull back, OPEC has lost its position as the balancer in the global oil market. That has now fallen to the United States.

And by pushing home its point, Saudi Arabia has managed to lose its leverage.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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