The case for Saudi Arabia increasing output

By: Harry Altham, Energy Analyst, Market Analysis EMEA & Asia

Mon, 04 Jul 2022, 10:52

The Case for Saudi Arabia Increasing Output

Harry Altham

Energy Analyst, EMEA & Asia

Brent has topped $114.75 this morning, with traders continuing to balance tight supplies with wobbling demand. On the back of a report by JP Morgan stating that oil could touch $380 if Russia retaliates to the proposed G7 price cap, a series of $300 October call options traded in Brent, although we view such a price as highly improbable. The policy would clash with the E.U. ban on Russian seaborne oil and would need to be globally enforced (which is unlikely factoring China and India). On the other hand, CitiGroup has issued its own report warning of oil falling to $65 in the event of a major recession at year’s end. Brent’s resistance level is the psychological marker of $115, while resistance is at 22nd June low of $107.03.

Boris johnson calls on Saudi ARABIA TO BOOST SUPPLY

After Vitol issued a report over the weekend stating that demand was being impacted by high prices, Boris Johnson became the latest leader to call on Saudi Arabia to boost supply in the hope that it would ease price pressure, despite the country failing to meet its quoted OPEC output hike for June. According to Energy Minister Prince Abdulaziz bin Salman, Saudi Arabia can currently produce a maximum of 12.0M bbd, which is projected to rise to 13.3M bbd by 2027. However, it is currently drawing 10.5M bbd and is unwilling to move out of lockstep with other OPEC nations, hence the pressure from Western nations to increase output. A further 1.4M bbd of spare capacity also exists between the U.A.E. and Iraq, with both countries looking to increase capacity by a further 1M bbd each by 2030.

Source: Bloomberg, S&P Global, Reuters, StoneX

Given the advantageous marginal cost of increasing production within current capacity constraints, we believe President Biden has a strong economic case to lobby the Saudi Government into boosting output. As long as average revenue ([AR] equivalent to demand) exceeds long run average costs [LRAC], Saudi Aramco is able to profit in oligopolistic markets (oligopolistic on a nation-to-nation basis). In the long run, sustaining profit close to maximum requires marginal cost to intersect average total cost at the point that the demand curve ‘kinks’, while in the short-run the AR curve needs to be shifted ‘outward’. As rising inflation is expected to impact spending on ‘luxuries’, including leisure travel and certain consumer goods, the inelasticity of demand for oil, and cross inelasticity of demand for secondary goods moves quantity demand towards the ‘elastic’ side of the kinked average revenue curve. Also, via DOE gasoline consumption data, we are seeing reduced disposable income causing an inward shift of the oil demand curve in Western economies; it is In Saudi Arabia’s economic interest to marginally boost output to keep oil prices below a level in which demand destruction could hamper its long run average revenue curve.

the kinked demand curve in oligopolistic markets

Source: Economics Online

in practice, POLITICS remains the RULE of THE LAND

However, this is very much a political game. When President Biden visits Mohammed Prince Salman this month, he will likely need to refrain from contentious issues and provide greater public support to Saudi Arabia, particularly in armaments deals in support of Saudi Arabia’s military campaign in Yemen. How far President Biden is willing to go is one major factor, the other is Saudi Arabia’s willingness to boost output without assistance from other OPEC members. Thus far, it has been beneficial for Saudi Arabia to move with OPEC as it has benefited from record revenues amid surging demand and tight supplies. Now though, could those changing economic dynamics cause a change of tack? We will monitor developments closely in the coming weeks.

Energy

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