The Economics of the Saudi's "take-the-money-and-run" Strategy

Steve H. Hanke's picture

As the Financial Times reported on 12 July, Saudi Arabia’s oil-output reached record highs in June 2016. Increasing production 280,000 barrels/day to 10.6m b/d, Saudi Arabia has once again waved off OPEC’s request not to glut the market with oil. 

As it turns out, economic principles explain why the Saudis began, in late 2014, to pump crude as fast as they could – or close to as fast as possible. In fact, there is a good reason why the Saudi princes are panicked and pumping. 

Let’s take a look at the simple analytics of production. The economic production rate for oil is determined by the following equation: P – V = MC, where P is the current market price of a barrel of oil, V is the present value of a barrel of reserves, and MC is the marginal recovery cost of a barrel of oil.

To understand the economics that drive the Saudis to increase their production, we must understand the forces that tend to raise the Saudis’ discount rates. To determine the present value of a barrel of reserves (V in our production equation), we must forecast the price that would be received from liquidating a barrel of reserves at some future date and then discount this price to present value. In consequence, when the discount rate is raised, the value of reserves (V) falls, the gross value of current production (P – V) rises, and increased rates of current production are justified.

When it comes to the political instability in the Middle East, the popular view is that increased tensions in the region will reduce oil production. However, economic analysis suggests that political instability and tensions (read: less certain property rights) will work to increase oil production.

Let’s suppose that the real risk-adjusted rate of discount, without any prospect of property expropriation, is 20% for the Saudis. Now, consider what happens to the discount rate if there is a 50-50 chance that a belligerent will overthrow the House of Saud within the next 10 years. In this case, in any given year, there would be a 6.7% chance of an overthrow. This risk to the Saudis would cause them to compute a new real risk-adjusted rate of discount, with the prospect of having their oil reserves expropriated. In this example, the relevant discount rate would increase to 28.6% from 20% (see the accompanying table for alternative scenarios). This increase in the discount rate will cause the present value of reserves to decrease dramatically. For example, the present value of $1 in 10 years at 20% is $0.16, while it is worth only $0.08 at 28.6%. The reduction in the present value of reserves will make increased current production more attractive because the gross value of current production (P – V) will be higher.

 

So, the Saudi princes are panicked and pumping oil today – a take the money and run strategy – because they know the oil reserves might not be theirs tomorrow. As they say, the neighborhood is unstable. In consequence, property rights are problematic. This state of affairs results in the rapid exploitation of oil reserves.

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shovelhead's picture

This makes sense. If you have what you consider, (or know) to be a depreciating asset in future terms, then common sense dictates selling as much volume at current prices as you can.

Mr.Hanke has run a probabilities table whose values could be arguable by someone with a more perfect knowledge of what's in the ground or what may happen above it but here we are left only with probabilities to work with. You couldn't walk 6 inches in Saudi Arabia without kicking a stone under which some risk could be hiding, from domestic discontent or Geo-political intrigues of their own and of others making.

This is a tough neighborhood and the Sauds have surrounded themselves with some "friends" of very dubious character much like their own.

If I were driving their Mercedes, I'll be going like a bat out of hell too, because a pocket full of cash beats a pocket full of regret when the SHTF.

 

Edit: Hey can you help a brother out here? My power went out with the internet in a storm last night and now I get a redirect "Page not found" when I hit Zerohedge. The banner articles are listed but the home page below is absent.

How to fix?

unklemunky's picture

I trust nothing that wears a skirt and has a beard. Soon they will be back to pumping camels.

overmedicatedundersexed's picture

using guesstimates like what the future value of V is ..are always very hard to swallow..what is very clear: us .gov has destablized the whole region, under D or R adm..what the purpose of continued removal of governments in the region(assad) is not for the public's eye..continued radicalization of millions of muslems seems one goal.

do not assume leaders in Me or in the west are vested in what's best for the country..all information on that points to NWO cabal that is power crazy.

Pasadena Phil's picture

IMHO, this is not purely about oil economics but about the Saudi family bailing with their wealth. The House of Faud offered to sell 5% of Aramco for $1 trillion while bequesting the rest to "the people". They are also looking to invest over a $1 trillion in Silicon Valley.  A July 20, 2016 WSJ article reported that they are tapping more than ever into their oil reserve stockpile for exports in trying to maintain their dwindling market shares in the US and Europe while their domestic demand soars. They are going out of business. They are projecting to no longer be exporting oil within the next 3-5 years. Add Venezuela and Nigeria and suddenly OPEC is turning into OPC.

I have never believed Saudi production numbers to begin with. They just make them up. I DO believe the various reports about how they peaked years ago and are running out of reserves. Depending on who you choose to believe, they have also been forgoing routine mainenance for years out of fear of losing even more market share. They are in decay and heading for serious production problems. The Saudi royal family is getting ready to cut and run before they are booted out or slaughtered by their own people.

This is all happening in the face of a US that is within striking distance of energy independence and has become the swing producer thanks to shale. And with removal of the domestic "global warming alarmists" from power this November, all road blocks on projects opening up the world for US exports will begin in earnest and the US will once again have control of the base price of global oil. It just doesn't look good for the terror-sponsoring countries. Somehow in all of the mayhem, someone found a way to drain the swamp of global terrorism: those evil oil companies. The US can finally extricate itself from permanent Mid East war.

unklemunky's picture

I agree. I am so sick of these mba type bullshit formulas. Almost always produced by someone who has never produced anything outside of an estimate no better than a coin toss. We can all do math. And who gives a shit. The sauds are pumping more oil to maintain their cashflow. Lower price =higher volume. Economies of shale.....hahahahah. I hope the fuckers go broke.

Miss Informed's picture

They would rather have gold that they can stash somewhere. The oil will belong to someone else after they are forced out.

Panic Mode's picture

I don't see how they can move on gold. They have been sleeping with wolf all along. If they do, US will retaliate in another way. Their agreement under the table are keeping US dollar float and keeping reserve in TB.

mabuhay1's picture

on the post about the Houthis attacks in Southern Saudi Arabia, these "bases" that were attacked were not military bases, but most likely border patrol stations or police stations. The villages listed are very small places located right adjacent to the Saudi Yemen border, and have little or no population nor military activity.
Most of the border region villages are isolated far from any main roads, large population centers, or large military bases. The local population part of the same tribal identity as the Houthis on the Yemen side of the border, and some may hold sympathy for the Houthis cause, but there is no real threat to Saudi control of the area.
Much of the reporting on activity in this area comes from Iranian Farsi news sources or sources not friendly to Saudi Arabia, and thus are suspect as to the truth of the reporting. Many times, reports of attacks on military bases in this area are sensationalized to make them seem much larger and successful than they really are by rebel sources, but also much of the English translations of the reports of the rebels are of poor quality in the begin with, and cannot be trusted.

Seeing Red's picture

This article is bullshit.  Oil is an inelastic commodity; slight changes in supply tend to create large changes in price (at least regarding crude).  The most likely reason the Saudis are producing so much that they LOSE money would be to hurt Russia.

Trying to conjure up an NPV-based argument for this is clever in a way, but it makes huge hidden assumptions [fixed oil price] (that are invalid given KSA is such a major player).  FAIL.

mkkby's picture

The insiders know more than the rest of us.  That is why EVERY IPO is about the insiders dumping to the clueless public.  If the Saudis are looking to IPO their oil fields, that is a signal that they sense a turning point.

Likedeeler's picture

The Saudis might also have recognized that a kilowatthour of sun does not cost much and sinks, which might influence the value P of liquid kilowatthours in the future as well.

conscious being's picture

After recent victories and the fact that Houthi forces have managed to successfully invade Saudi territory, KSA’s weakness appears to be even greater than what many informed observers may have suspected.

Houthis Launch Ballistic Missile Counter-Offensive

BorisTheBlade's picture

It all makes sense, KSA is also building the biggest tanker fleet, bigger than China's: http://www.bloomberg.com/news/articles/2016-07-18/saudi-arabia-seeks-to-create-biggest-tanker-fleet-with-new-fund

I suspect they know what's up. Article's discount rates seem to be based upon 1987 estimate, which was a very different time with ME not being in flames to the extent it is right now. What if Saudis estimate there is major disruption with 50% chance over the next 2 years, that would actually push the timeline for them considerably and increase discount rate much more. At this point they don't care about long term sustainability of oil production, just pump sea water into wells and extract and sell everything, strip their main asset s fast as possible. That will screw up their oil production fairly quickly, or to whoever comes after: either way Saudi production might fall off the cliff over the next two years.

RaceToTheBottom's picture

No problem, all those princes can just be financial advisors.....

joego1's picture

Thank you Mr. Hanke