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Cathy Holcombe

Oil is a sector particularly prone to conspiracy theory, and the recent surprise plunge in prices hasn't disappointed on that front.
Even the editorial pages of The  New York Times  hosted a nefarious-plot theory, offered by Thomas Friedman. In a recent column the former Middle East correspondent asked: "Is it just my imagination or is there a global oil war underway pitting the United States and Saudi Arabia on one side against Russia and Iran on the other?"
He then went on to answer his question in the affirmative, arguing that the Saudi-US alliance is trying to "pump to death" political foes Iran and Russia, whose fiscal budgets heavily rely on oil revenues.
We have since learned that President Obama secretly reached out to Iran's president in the fight against ISIS, as the group was formerly called, so it is possible that Friedman got a call from the Department of State that began with the words, "Listen up, you bozo…"

But this narrative also has big currency in Russia, with Pravda newspaper headlines such as: "Obama Wants Saudi Arabia to Destroy Our Economy."
As the producer with the most excess capacity, Saudi Arabia has long been the swing factor in this market, raising production to cool price bubbles, and cutting output to support the market when prices are crashing.
After oil prices began tanking in the late summer, the country was expected to reduce production as per usual. But instead, last month Riyadh announced that it will focus on "maintaining market share" rather than cutting supply to support price.
A political explanation is very tempting. But there are a number of economic motivations that could also rationally explain the new Saudi business strategy.
Most obviously, the US is not just an extremely awkward political ally for Saudi Arabia. It has also traditionally been a huge gas-guzzling customer for the kingdom's crude but now, thanks to the "shale revolution," is a major competitor.
One tactic to deal with such a competitive threat is to push prices to where the shale producers - who have a higher cost base than the Saudis - are forced to retreat. The Saudis have not been able to employ this tactic as yet, because so many supply and political factors were keeping oil prices well above shale production costs.
But in recent months global oil supply surprised on the upside, and demand on the downside. With prices down some 25 per cent since June, to below US$80 a barrel last week, some believe the Saudis have seized on this chance to put a squeeze on the shale cowboys.
A simple and elegant explanation, and one making the rounds in Texas these days.
But according to Goldman Sachs, it's too late to play that game. The reality is thus more complex.
"We believe that once shale production exceeded Saudi's spare production capacity, Saudi lost the ability to derail the economics of shale extraction," Goldman wrote in a research report headlined by Damien Courvalin.
The large US capacity means Saudi Arabia is no longer an effective monopolist who can swing prices, but has been downgraded to "dominant firm" status, the report said. Economic theory would suggest Riyadh should now focus more on market share, and less on prices - which is exactly what has happened.
"This shift in behaviour, while unexpected, is consistent with the economics of 'dominant firm/competitive fringe' market structure once it became apparent that shale oil production is sustainable," according to the bank.
If the Saudis cut now to support prices, the Americans could go for the jugular, ramping up their production. The Arabian Peninsula would end up with nothing more than lost revenues.
The best remaining strategy for the Saudis is to force the Americans to become the new supplier of the swing barrel.
Of course, it is possible that such a complex plot might also serve to conveniently distract clients from the fact that Goldman, like basically every other bank, did not predict this fallout in oil prices.
But enough of conspiracy theory. The "dominant firm/competitive fringe" narrative is very compelling one, and too important to ignore.
Because if true, the implications are huge. It would mean this jolting drop in prices isn't a blip; frequent price wars between the world's two biggest oil producers could become a built-in feature of the global oil landscape.


The plot thickens in oil price plunge theories

Oil prices have gone down some 25 per cent since June. Photo: Reuters


Business

Commodities

Opinion

Comment

Plunge in oil prices may have more to do with economic theory than Russia-Iran conspiracy theory


Oil is a sector particularly prone to conspiracy theory, and the recent surprise plunge in prices hasn't disappointed on that front.


Expresses the views, ideas and conclusions of the author. (Eg. Enough of Crazy Rich Asians, think of crazy poor Hongkongers.)


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The View

The View | The plot thickens in oil price plunge theories

Plunge in oil prices may have more to do with economic theory than Russia-Iran conspiracy theory