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Why Saudi and American bluffing won't lower oil prices (Hint: It doesn't work when people know you're bluffing)

If you have the power and the desire to bring down oil prices, the best way to proceed is to start bringing them down. The easiest and fastest method would be to make more supplies available to the world market and keep adding until you reach your target price. The less you say about what you are doing, the better. When market participants are filled with uncertainty about your intentions, they have only the direction of prices to guide them. That means the speculative players can help you achieve your goals more quickly as they panic out of their positions.

This was not, of course, the path chosen by the United States, Great Britain and Saudi Arabia recently when they announced that they were contemplating intervention in the oil markets--in the form of releases from strategic petroleum reserves in the case of the United States and Britain and in the form of increased production by Saudi Arabia.

It seems that while all three countries have the stated wish to bring down oil prices, they appear to lack the power or at least the desire to do so. So, they are left with bluffing. It's true that oil markets move on rumors and sentiment, but not as far nor for as long as people believe. The joint U.S.-Great Britain announcement caused oil prices to fall sharply the same day before recovering nearly the entire loss by the close. The Saudi announcement that it might increase production caused a sharper one-day fall which was largely recouped the following day.

Oil prices are ultimately tied to the delivery of actual oil. Unlike, say, stock prices, which can become unhinged from fundamental conditions for companies or the economy as a whole for long periods, oil prices are constantly being disciplined by actual supply and demand in the real world. Short-term misperceptions can occasionally drive the price to unsustainable highs or lows, but not for very long.

What oil market participants took away from the two tightly spaced announcements was that neither party is serious about doing much of anything. It seems unlikely the United States and Great Britain would dip significantly into their strategic reserves at a time when a war with Iran could break out at a moment's notice--not so much because the United States and Britain want war, but because Israel may act unilaterally to start one. A war with Iran would constitute a real emergency, and so, draining strategic reserves now to appease voter concern over high gasoline prices might prove foolhardy. Unless war with Iran breaks out, look for a token release of oil if such a release comes at all.

As for Saudi Arabia, the question is not whether the country could increase production, but how much, for how long, and of what kind of oil. The Saudis announced late last year that they were stopping their capacity expansion program because they had reached their target of 12.5 million barrels per day. But that new capacity has yet to be tested. Saudi production currently stands at about 10 million barrels per day. We do not know for certain what output Saudi Arabia could achieve over this on a sustained basis. And, even if the Saudis could increase their oil production substantially, would they really want to? They would risk adding supply in the face of a faltering European economy that could pull the legs out from under oil demand thus crashing prices far below the level the Saudis and their friends in OPEC really desire.

The reports that Saudi Aramco's shipping arm, Vela, has been chartering extra very large crude carriers which can carry up to 2 million barrels of oil should be taken with a grain of salt. It's hard to know whether this means the country is actually increasing total world supply or whether it means that Vela simply found its own fleet committed and needed to hire tankers from other shippers. We should take note that the Saudi oil minister admitted that his country's March and April oil production would be essentially unchanged. In this context, a Financial Times article (via The Globe and Mail) entitled "The price that launched a wall of ships" seems like another public relations plant by the Saudis designed to manipulate market sentiment. In any case, crude futures prices had by the end of trading last week regained almost the entire loss suffered after the piece appeared.

There is also the question of what kind of oil would make up any extra Saudi production. Not all oil is the same. Arab light is highly prized for its ease in refining. Most refineries in the world are designed to refine light crude with low sulfur content. Saudi Arabia is adding capacity from a new offshore field and from a previously mothballed onshore field both of which produce heavy crude, a less desirable crude that is more difficult and costly to refine. This tells us that while Saudi Arabia may be able to supply extra oil to the market, it may not be the kind of oil that the market can easily absorb.

Saudi actions beg this question: If the desert kingdom has so much oil left under its territory, why it is scraping the bottom of the barrel offshore and at an old field that was closed in 1980?

It's likely that market participants already understand all this and that's why they see the recent announcements by the United States, Great Britain and Saudi Arabia for what they are: bluffs.

What would bring oil prices down quickly in the short term is an economic slowdown, a possibility about which economists and market analysts are split. The slowdown would, of course, reduce demand for oil and oil products. A longer term strategy would be to move away from dependence on oil. That would take political courage and discipline, but Europeans seem to have long since accepted this strategy. Germany and Italy, for example, have both been gradually reducing their total petroleum consumption since 1998. In Asia, Japan's overall consumption has been declining since 1996.

The world clamors for cheap energy as an addict clamors for a cheap fix. Both behaviors result in less than optimal outcomes until the parties involved realize it's time for some serious treatment. Europe and Japan are leading the way. Will America have the wisdom and ingenuity to follow them?

Kurt Cobb is the author of the peak-oil-themed thriller, Prelude, and a columnist for the Paris-based science news site Scitizen. His work has also been featured on Energy Bulletin, The Oil Drum, 321energy, Common Dreams, Le Monde Diplomatique, EV World, and many other sites. He maintains a blog called Resource Insights.


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