In the last quarter of 2014, in the face of possible oversupply, Saudi Arabia abandoned its traditional role as the global oil market's swing producer and therefore it role as unofficial guarantor of existing ($100+ per barrel) prices.
In October, Saudi sources first prepared the market with statements that the country would be comfortable with oil prices as low as $80 per barrel for "a year or two." At the November OPEC meeting, the Saudi oil minister, Ali Al-Naimi, publicly announced Saudi Arabia would allow market forces to set prices. He argued that rapidly growing production outside OPEC made the existing status quo unviable, and that lower prices in the short term would increase prices in the longer term through reduced investment and ultimately benefit all OPEC members.
Parallel with this shift, Saudi officials expressed confidence in their country's financial wherewithal to withstand the repercussions of lower oil prices.
The Saudis Expected a Hole, Not a Bottomless Pit
The Saudis obviously miscalculated the degree to which their shift would negatively impact oil prices. The average price of Brent, the global benchmark, fell below the Saudis' $80 floor in November, fell to $62.34 in December, then fell below $50 in February. Prices rebounded to $60 for a few months, before falling once again below $50.
Plunging oil prices have substantially reduced Saudi revenues. With Brent prices averaging roughly $100 per barrel in 2014, Saudi oil exports of 6.31 million barrels per day would have generated roughly $631 million in revenues daily. In the first quarter, with Brent prices averaging $53.92, the same output would have generated roughly $340 million daily, $291 million less per day than oil at $100 per barrel.
The Saudis have attempted to mitigate the revenue shortfall through increased production, ramping up output from 9.6 million barrels per day in the fourth quarter of 2014 to an eye-popping 10.5 million barrels per day in June.
The revenue from increased production, however, is overwhelmed by the collapse of prices, which has ripped a substantial hole in the Saudi budget. In December 2014, the Saudi government approved spending $229 billion in 2015, resulting in an estimated deficit of $39 billion, or some 5% of GDP.
As mid-year 2015 approached, the IMF estimated the budget deficit would equal approximately 20% of Saudi GDP. The Financial Times quoted analysts as estimating the Saudi budget deficit in 2015 at $130 billion. Even with massive deficit spending, the IMF estimated GDP growth would slow from 3.6% in 2014 to 3.3% in 2015, and then just 2.7% in 2016.
Racing to Barrel Oil
The Saudi miscalculation has several sources. One is the negative feedback loop between oil production, GDP, and national budgets that plagues many non-Western oil producers. Their GDP and national budgets depend significantly on the revenues from their oil exports. As a result, the revenue shortfalls incentivize them to produce as much oil as possible to mitigate the shortfall.
According to the IEA, daily output in June 2015 increased 3.1 million barrels over 2014, with 60% (1.8 million barrels) coming from OPEC. At 31.7 million barrels per day, OPEC output reached a three-year high.
This increase in output occurs with the context of a narrow global demand opportunity. Growth in demand in 2015, which the IEA forecasts to average around 1.4 million barrels per day, comes primarily from Asia and North America. In other major export markets, demand is stagnant. That has oil exporting countries, including OPEC members, Russia and others, focusing their sales on Asia, particularly China. North American demand is growing now that oil prices are low, but due to high levels of domestic production, the U.S. is no longer a growth market for oil exporters.
Each producer, therefore, is incentivized to undercut other producers directly (price per barrel) or indirectly (absorbing shipping cost or delivery risk) to win sales in Asia (or displace incumbent suppliers in other major markets). National oil producers can and are shifting the cost of the lowered prices to other sectors of the economy. The U.A.E., for example, has ended fuel subsidies, thereby essentially, increasing its budget revenues, while Saudi Arabia recently floated a $4 billion domestic bond offering to help finance its budget.
Asian customers are taking advantage of the competition. They are reducing the share of long-term contracts in favor of spot purchases. For example, as the Wall Street Journalreported, some Japanese refiners are cutting the proportion of oil purchased through long-term contracts to around 70% from more than 90%, while some South Korean refiners are reducing the proportion from 75 to 50%. Furthermore, several national oil companies, Venezuela's among them, are building refineries with local partners in Asia, which will use their crude.
Given this environment, it is not surprising that the revenue elasticity of production is highly sensitive, and negative. Saudi Arabia increased production by 6.8% in the first quarter of 2015 but saw export revenues shrink by 42%.