Is Saudi Arabia part of the reason for oil's new price highs?
Petrologistics, a Swiss firm that tries to count the physical quantities of oil produced and shipped by tankers, has been reporting that Saudi Arabia produced under 9.1 million barrels per day during April, May, and June. The same numbers have also been reported in recent press statements from the Saudis [1], [2], and would represent a 400,000 barrel a day cut from what Saudi Arabia had been producing for most of 2005.
The interesting question is what this means. A recent article from Reuters declared that these production cutbacks prove that supply and demand are irrelevant for the price of oil:
Oil power Saudi Arabia has offered the most compelling proof yet that record high prices are divorced from the realities of supply and demand. The world's biggest crude exporter dared to make a huge cut in its production through the second quarter but growing demand for oil was still satisfied....
"There is absolutely no relationship between price and supply and demand," Saudi Oil Minister Ali Al-Naimi noted. He told pan-Arab newspaper Al Hayat in early June that crude oil was worth no more than $50 a barrel based on fundamentals. He has repeatedly said the oil price is determined by the multi-billion dollar market that brings together oil companies, traders, investment and hedge funds.
"The reason for the cutback is simple. People are not asking for oil," said a senior OPEC delegate. Heavy refinery maintenance, especially in Asia, dampened demand and tanks continued to fill.
There is nothing mystical or mysterious about the process whereby hedge fund speculation leads to an increase in the price of oil. If more people are trying to buy rather than sell oil futures contracts, the price of these contracts is bid up. If the current spot price of oil did not go up with it, that would create an arbitrage opportunity for anybody to put more oil into storage today which they can then sell forward risk-free through a futures contract. The oil put into storage for this purpose is an added component of the demand for the liquid, in addition to that coming from refineries intending to use it in the present period. This is the mechanism by which increased speculation in "paper" oil translates directly into an added component of the demand for physical liquid barrels.
It should be perfectly clear that while speculation adds to the demand for oil and thereby can drive the price up, if Saudi Arabia or anybody else produces more oil, that means that more oil is available on the selling side of these contracts, and the lower would be the resulting equilibrium price. If the Saudis do not find buyers for the particular grades of oil they are producing, they could either discount the price of that oil or lower production. Which they do is a choice the Saudis make, not the mysterious outcome of hedge fund speculation. It may well be that the Saudis are experiencing lower demand, but if so, it is their cutbacks in production that are causing the price to rise rather than fall in such a situation.
One can speculate on the nature of that reduced demand for Saudi oil. Petrologistics offers these details:
Oil power Saudi Arabia has cut exports to Asia by over half a million barrels a day since March to match lower demand from refiners during their springtime overhauls, tanker tracker Petrologistics said on Wednesday.
That has been the case during the second quarter with Saudi Arabia shipping 220,000 bpd less crude to Asia in May than April, said Conrad Gerber, the head of Petrologistics. Exports in April were already 350,000 bpd less than March, he said.
Buyers in the west took 180,000 bpd more Saudi crude in May than April, compensating in part for the fall in the flow to Asia. The flow to western buyers in April was 150,000 bpd less than March, Petrologistics said.
It is interesting to read that story side-by-side with Bloomberg's report that Japanese refiners plan to buy most of the 250,000 barrels per day expected to start flowing soon from Russia's Sakhalin-1 project. It certainly makes sense for Japan to buy less oil from Saudi Arabia and more from Russia, from the perspectives of transportation logistics (the Russian port is 10 times closer) and diversification of supply.
One also wonders whether the "springtime overhauls from Asian refineries" is related to this story from from Reuters:
China will extend a 50,000 barrel per day (bpd) cut in Saudi crude oil imports into July and August after some refiners struggled to cope with new higher-sulphur supplies, industry officials said.
China contracted to buy 500,000 bpd of Saudi crude in 2006, but cut that back by 10 percent in the second quarter after refiners ill-equipped to handle the kingdom's mainly heavy-sour oil were forced to slow production after running the grades, the officials said.
It's also interesting to note that these drops in Saudi production have coincided with a huge increase in Saudi drilling efforts. The graph below, taken from the Oil Drum, shows estimates of Saudi production from the U.S. Energy Information Administration (green line) and the Joint Oil Data Initiative (purple) along with the number of oil rigs in operation (blue). The Saudi explanation is that they are aggressively trying to develop more excess capacity, though, if that's their intention, why not use existing capacity to prevent the price from rising to $75? One can't help but wonder that, when Saudi production peaks, the graphs and official statements might be quite similar to what we're seeing right here. That possibility is conceivably one of the factors driving those investment funds to keep on buying oil futures.
More questions than answers at this point. But definitely a story worth following closely.
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