October 16, 2018 / 1:37 PM / a month ago

Commentary: Saudi Arabia's oil weapon doesn't work

LONDON (Reuters) - Saudi Arabia is unlikely to employ its so-called “oil weapon” in the diplomatic crisis over the disappearance of a journalist after visiting the country’s consulate in Istanbul.

An oil tanker is being loaded at Saudi Aramco's Ras Tanura oil refinery and oil terminal in Saudi Arabia May 21, 2018. REUTERS/Ahmed Jadallah

Experience from the last time Saudi Arabia tried to use oil sales as a diplomatic instrument in 1973/74 shows such action does not work and the kingdom itself would be the biggest victim.

Despite some of the impassioned rhetoric in Saudi media, self-interest makes it improbable the government will retaliate by reducing oil sales or trying to drive up prices.

That has not stopped some veiled threats to weaponise oil production and prices, but they should be interpreted as an urgent plea for support and understanding rather than a serious threat.

“If U.S. sanctions are imposed on Saudi Arabia, we will be facing an economic disaster that would rock the entire world,” according to one heated editorial (“U.S. sanctions would mean Washington is stabbing itself”, Al Arabiya, Oct. 14).

“Riyadh is the capital of (global) oil and touching this would affect oil production before any other vital commodity,” the editorial warned.

If the price of oil reaching $80 a barrel angered U.S. President Donald Trump, “no one should rule out the price jumping to $100, or $200, or even double that figure”, the author said bluntly.

The government’s official response has been more circumspect but it nonetheless warned that it would respond to any action with even greater retaliation and pointed to the kingdom’s “influential and vital role in the global economy”.

OIL EMBARGO

In October 1973, Saudi Arabia and the other Arab oil producers announced that they would start cutting production by 5 percent per month until Israeli forces evacuated from occupied Arab territories.

In addition, Saudi Arabia and the other Arab producers announced an embargo on oil sales to the United States and a number of other countries (“OPEC: 25 years of prices and politics”, Skeet, 1988).

Global oil supplies had already become tight even before the decisions to cut production and embargo the United States, mostly as a result of low real prices during the 1950 and 1960s.

Spare production capacity in the United States, which had been as much as 4 million barrels per day in 1968, had been used up by March 1972.

(Graphic: reut.rs/2yGbLTC)

In this context, the production cuts and embargo made an already tight market worse, sent oil prices surging, and produced a huge, short-term revenue windfall for Saudi Arabia and other oil producers.

But the policy was a failure in its own terms, was reversed a few months later, and caused immense long-term damage to Saudi Arabia and OPEC that took decades to reverse.

POLICY FAILURE

At the most basic level, the policy failed to achieve its stated objective of changing U.S. support for Israel or forcing Israel to withdraw from the occupied Palestinian territories.

More seriously for Saudi Arabia and other Arab oil producers, the surge in prices, which rose again after the Iranian revolution in 1979, resulted in permanent demand destruction and encouragement of alternative suppliers.

Rising prices helped spur the development of new supplies in Alaska, the North Sea, the Soviet Union and China, which came onstream and flooded the oil market in the 1980s.

Rising prices also encouraged a wholesale switch away from the use of crude oil and heavy fuel oil in residential and commercial heating boilers as well as in power generation.

Homes and offices in the United States and many other advanced economies switched from heavy fuel oil to cheaper and more reliable heating using natural gas or electricity generated from coal or nuclear.

Crude oil and fuel oil were replaced by a new generation of coal-fired power plants in the United States in the late 1970s and the 1980s (ironically the same coal plants that are now being closed and replaced by natural gas).

The oil shock also provided the impetus to develop a new generation of nuclear power plants in the United States, France, Japan, Britain and other countries to reduce the reliance on imported crude.

Cheap oil had been on the way to becoming the dominant fuel for power generation in the 1950s and 1960s, putting the coal industry under pressure.

By the late 1980s, however, expensive and unreliable oil had been largely pushed out of the power sector by cheaper and more secure coal, gas and nuclear, a permanent loss of markets from which it has never recovered.

Policymakers in the United States, Europe and Japan also enacted new fuel-economy standards for motor vehicles to reduce reliance on imports for the transport sector, taking another enduring bite out of demand.

In the long term, the oil embargo created the conditions for the oil price slump that hit Saudi Arabia and other producers in the 1980s and 1990s, and from which they did not recover until the 2000s.

WEAPON MALFUNCTION

The oil weapon does not work, which is why Saudi Arabia is unlikely to employ it in the dispute over the disappearance of Washington Post journalist Jamal Khashoggi.

In the short term, Saudi Arabia might gain more revenue from a rise in prices than it lost from a reduction in sales. But rising prices would hit the global economy and consumption hard and threaten a renewed oil market slump within a year.

The weapon cannot be wielded in a targeted way against specific consuming countries because the oil market is global and fully integrated. Restricting supplies to punish some countries pushes up oil prices for all consumers.

Wielding the oil weapon to pressure the United States would impose bigger costs on China and India, which are the largest and fastest-growing oil importers and crucial markets for the future.

Saudi Arabia has spent decades marketing itself as a reliable oil supplier, especially to customers in Asia, and any attempt to employ the oil weapon would destroy that carefully crafted reputation.

Saudi Arabia’s refining customers would instead turn to Iran, Russia and the United States for additional supplies and likely reconsider their long-term dependence on the kingdom.

If Saudi Arabia nonetheless attempted to weaponise oil production and sales, the resulting surge in prices would prompt another round of conservation measures cutting long-term demand for its main product.

Sharp rises in oil prices would put a renewed focus on vehicle fuel economy standards as well as accelerating the deployment of electric vehicles.

Rising prices and concerns about unreliable supplies would speed the diffusion of electric vehicles and push oil out of the transport market just as it was pushed out of heating and power generation in the 1980s.

Saudi Arabia has spent years urging oil-consuming countries to remember it needs “security of demand” just as much as they need “security of supply”.

But weaponising oil production would break that understanding and provoke a backlash from consuming countries with a concerted effort to reduce their oil imports.

Finally, Saudi Arabia relies heavily on the United States for security (including the provision of advanced weapons systems, training, intelligence and thousands of U.S. personnel and aircraft stationed in and around the Gulf).

There is no way to wield the oil weapon which would not shake the foundations of the U.S.-Saudi alliance on which the kingdom’s defence depends, leaving it vulnerable to regional rivals, including Iran.

For all these reasons, the oil weapon is essentially useless, an unreliable blunderbuss more likely to blow up the user than its intended target, which is why Saudi Arabia is unlikely to deploy it.

John Kemp is a Reuters market analyst. The views expressed are his own.

Further reading:

- “OPEC: the inside story”, Terzian, 1985

- “OPEC: 25 years of prices and politics”, Skeet, 1988

- “King Faisal of Saudi Arabia: personality, faith and times”, Vassiliev, 2012

- “The Caravan Goes On: how Aramco and Saudi Arabia grew up together”, Jungers, 2013

Editing by Dale Hudson

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