Oil at $40 by Steven Kyle

Here’s another post by Steven Kyle… I apologize to him and the readers in advance – I botched his table. One of these years I have to learn how to post pictures….

Oil at $40???
It has been reported recently that one option being bandied about to counter the growing influence of Iran is a plan to “make the price of oil plummet” to $40 a barrel. (See Steve Clemons’ report here) There are two questions that arise from this.
1. Can they do it?
2. Would it work?
In answer to the first question, it is instructive to look at the current OPEC oil production capacities since the key player in achieving an oil price crash would be Saudi Arabia which would have to produce at maximum capacity until the price came down from its current level of a bit over $60. The table below, from the US Energy Information Administration (here) has the basic information. The table shows Saudi excess capacity of around 1.5 mbd, or about 5% of current OPEC total production. We know from various econometric studies that the short term demand for oil is highly inelastic (See e.g here) so in theory it is possible, at least for a while, but one question is whether some other country could “undo” the Saudi move by decreasing their own production. Certainly Iran itself could do so by cutting their own production – in fact, they would be in a situation where the money they would lose by doing that would be not drastically different from the amount they would lose from a price decrease to $40.
Table 3a. OPEC Oil Production
(Thousand Barrels Per Day)
(Energy Information Administration\Short-Term Energy Outlook — November 2006)

Member_Production__Capacity_Surplus Capacity
Algeria ______1430___1430______0
Saudi Arabia__9200_10500-11500_1300-1800
So the real problem isn’t necessarily the purely economic question of supply and demand elasticities. A plan to manipulate the oil market would require everyone else active in the market (oil companies, other OPEC countries, etc.) to go along and it is far from obvious that they would. Not only do the oil companies have an obvious interest in keeping the price up but so do all other oil producers. While their record of restraint in honor of collusive behavior is not very impressive in the past, it is also important to note that the need for restraint would only be temporary – nobody imagines that the Saudis would want a permanently lower oil price. In fact, it isn’t obvious that they would go along even in the short run.
From the demand side, though short term elasticities are very low, the same cannot be said of the long term. Not only do importing countries adjust to oil prices, but as their economies grow their demand shifts continuously outward over time. This is a factor contributing to the “peak oil” debate over the past few years. Cheap oil would mean a reduced effort to conserve and increased growth for major importers as the positive shock of lower import prices filtered through their economies. This would cause upward pressures on the oil price as soon as the Saudi induced slack was worked out.
As it happens, we have recent evidence on the effect of a 1.5 mbd shock in world oil markets, though in the opposite direction – When hurricane Katrina hit there was a loss of about that size to the world market but oil prices went up only $10. While there is obviously a difference between a cut of that size and an equal increase, we have to be suspicious of claims that an increase of $1.5 mbd could generate a price drop twice as large as a decrease of the same magnitude. All of these considerations mean that the answer to the first question even looking only at the supply side has to be “almost certainly not” and once we look at the demand side “definitely not”.
As to the second question, whether an oil price crash would “work” to rein in the Iranians, the numbers certainly look big but the real issue is non-economic. There is no question Iran would suffer from a financial hit as large as 40% of their oil income which is currently somewhere in the range of $50 billion a year. (See here for a summary of Iran’s oil reserves and production) This is a loss on the order of 5% of GDP if one uses PPP values for GDP, but as much as 15-20% at the official exchange rate – painful in aggregate terms but much more so for the government which is 90% dependent on oil revenue. So the government would lose something like 40% of its revenue – Clearly a hardship but would it bring the government down? The Iranian theocrats don’t seem ready to go anywhere and seem in fact to be strengthened every time the US makes another move against them. And with a foreign exchange reserve fund of around $15 billion (See here) they have room to maneuver.
So the bottom line is that the US State Department needs to get down to doing its job – talking to other countries to persuade them to do what we would like them to do – rather than engaging in pie in the sky searches for silver bullets to make other countries knuckle under through use of brute force, either military or economic.
Besides, it isn’t too hard to imagine a scenario that would give us temporarily lower oil prices even without grand politico-economic manipulations. If we get an increase in supply from the surge in oil drilling sparked by the price rises over the past two years, a recession in the OECD could well give us a drop in oil prices into the forties without any other actions taken. But this is unlikely to be anything more than a temporary phenomenon – the long term trend seems clearly to be up and as I was told many times during my previous incarnation as a bond trader “the trend is your friend”.