The Saudis Can't Save the Oil Market
by Kent Moors Ph.D. published June 10th, 2011

The oil markets are in decline today on the heels of a Saudi decision to provide additional crude volume.
The move comes as divisions within OPEC intensify (for reasons we discussed in "What Iran's Oil ‘Musical Chairs' Could Mean for the Region," June 3, 2011). There is still no indication how much additional Saudi oil will be flowing, but the prospect alone was enough to move the market price down more than 2.5% in New York and 1% in London.
The question now is whether the decision in Riyadh – and the extra volume – will be enough to bring balance to the market and subdue existing pressures that are pushing the oil price higher.
In a word, no.

The respite will, in fact, provide two contrary results.
Result No. 1: Sets A Price Ceiling (But Only Short Term)
The first is a short-term price ceiling in major price hikes. This is absent, of course, developments from other quarters – inventory constrictions, the lowering value of the dollar, continuing increases in global demand, and geopolitical developments, among others.
And anyway, it is not going to hold very long.
That's because the actual amount of crude Saudi Aramco can bring to the market for a protracted period of time is now suspect. Aramco itself is currently providing somewhere around nine million barrels per day, and it has a cap at about 12.5 million barrels.
OK, so they have plenty to spare, right? Well, not exactly.
Worldwide demand is advancing much more quickly than even OPEC has estimated. They have been forced to raise demand estimates significantly, a matter I have addressed on several occasions. (See "Can the Saudis Deliver the Oil the World Needs?" February 25, 2011, and "OPEC's New President: Watch Out, It's Coming," September 20, 2010).
OPEC does not set prices, as such.
The cartel first determines international demand. Then it subtracts non-OPEC production, resulting in what is referred to as "the call on OPEC." Once that figure is reached, it then assigns monthly production quotas to its member countries.
Now, there are a number of factors that collide in determining the price. And these days, they are accentuated by exceptional trading volatility that distorts the process even further. All of this adds to instability.
But when it comes to Saudi's action today, the ability to offset rising global demand become paramount.
Indications are that we will reach a demand figure of more than 89 million barrels a day by the end of the year, with projections putting the total at 92 million or more by 2015. That will essentially dry up the entire Saudi surplus – assuming that oil flow is even sustainable at full throttle (a matter under debate among oil analysts).
Oil traders, of course, will hardly wait that long. Well before the market reaches that point, the price will be rising in anticipation.
In a "normal" market – and we have not seen one of those in some time – traders will peg price to the cost of the next available barrel. However, in an unstable market, the price is tied to the most expensive next available barrel. And that guarantees rising futures… with or without Saudi additional volume.
The second result from the Saudi action moves in a very different, very disquieting, direction…

Result No. 2: Brings the "Asian Premium" Back
To offset what it sees as a need to provide energy to stimulate the ongoing Western economic malaise, this action is going to shortchange other regions.
Traders are now anticipating a rebalancing of Saudi exports to Europe and, to a lesser extent, the U.S., requiring a cut in exports rates to Asia.
This will reintroduce the "Asian premium" – an additional cost paid by Asian end-users in importing Saudi crude.
That premium had been lessening of late, as prospects for additional Russian crude deliveries through the East Siberia-Pacific Ocean (ESPO) pipeline brought competition to Saudi exports from a better grade of crude.
Now it's coming back – bringing a certain amount of economic consequence with it.
Asian markets themselves have dealt with this pricing imbalance before and will weather it this time around. Yet it will still have an effect on measuring productivity levels in the most rapidly expanding part of the globe.
As for the West… Additional Saudi crude will have some impact, but only marginal, in arresting further pricing acceleration.
Several Saudi officials have also said they would prefer a pricing range of between $70 and $80 a barrel. The rest of OPEC will not accept that, of course, and that means Saudi Arabia will need to move maximum production to reach its own suppressed price target.
Even if that were to be successful, the needle would rise. Because lowering prices always increases usage. And the very further increase in global demand beyond current estimates is one result the Saudis do find disconcerting.
It dries up the surplus they can bring to market… even faster.
Sincerely,
Kent