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Saudi Arabia Table of Contents

Saudi Arabia

Crude Oil Production and Pricing Policy

The kingdom's oil policy was based on three factors: maintaining moderate international oil prices to ensure the long- term use of crude oil as a major energy source; developing sufficient excess capacity to stabilize oil markets in the short run and maintain the importance of the kingdom and its permanence to the West as a crucial source of oil in the long term; obtaining minimum oil revenues to further the development of the economy and prevent fundamental changes in the domestic political system.

Short-term oil policy in the early 1990s has been shaped by two major sequences of events. The first was Saudi Arabia's refusal to play the role of "swing producer" in the mid-1980s, its subsequent bid to maintain its market share, and abandonment of the fixed oil price system after the 1986 price crash. The second was Iraq's invasion of Kuwait, the kingdom's replacement of most of the oil lost from these two OPEC members, and its ascendance as unchallenged leader within OPEC after August 1990. Both periods have shaped an oil policy that called for OPEC decisions to promote moderate and stable oil prices but not compromise the kingdom's demand for its market share. Before the Persian Gulf War, Saudi Arabia demanded about 25 percent of the OPEC production ceiling; after the Iraqi invasion of Kuwait the share rose to 35 percent.

Saudi Arabia's behavior in the oil market since 1986 demonstrated its attempts to ensure both goals. In the early 1980s, oil prices rose rapidly because of the breakdown of the old vertically integrated system of multinational oil companies, following nationalizations by producer governments during the 1970s. Other causes of the price rises were the disruption of Iranian exports during and after the Iranian Revolution in 1979, and the destruction of the Iranian and Iraqi oil sectors during the Iran-Iraq War of 1980-88, which exacerbated an already low level of spare production capacity. High oil prices in the early 1980s stimulated the rapid growth of non-OPEC oil supplies in the Third World, in Siberia, the North Sea, and Alaska.

As a result, oil prices began to drop in late 1982, forcing OPEC to institute a voluntary output reduction system by assigning individual quotas. The new system failed to stem the price slide, however. By 1985 spot (see Glossary) oil prices had fallen to about US$25 per barrel from an average of US$32 per barrel in the early 1980s.

Saudi Arabia's adherence to an official price system, which most OPEC members were abandoning, rendered the kingdom the swing producer. As a result, Saudi Arabia was forced to curtail output to ever lower levels. Other members "cheated" on their quotas by offering competitive prices, effectively pushing the entire burden of adjustment onto Saudi Arabia. In 1979-80, Saudi Arabia had peaked at a production of more than 10 million bpd; by 1986, that amount had reached a low point of 3 million bpd.

In early 1986, Saudi Arabia discontinued selling its oil at official prices and switched to a market-based pricing system called netback pricing--that guaranteed purchasers a certain refining margin. In doing so, Saudi Arabia recaptured a significant market share from the rest of OPEC. The sharp rise in crude oil supplies precipitated the crash of spot prices from an average of US$28 per barrel in 1985 to US$14 per barrel in 1986. The Saudis had used their "oil weapon"--significant excess capacity combined with adequate foreign financial reserves cushioning the blow of lower oil revenues--to establish some discipline in OPEC.

It did not take long before OPEC agreed to a new set of quotas tied to a price target of US$18 per barrel. By late 1986 and early 1987, prices rose to US$15 or US$16 per barrel for the OPEC basket (from well below US$10 per barrel in early 1986). To avoid a swing producer role, the Saudis imposed an important condition on other OPEC members: a guaranteed quota of approximately 25 percent of the total output ceiling, correlated to a US$18 per barrel price objective.

The latter became the center of controversy within the organization for much of the period before the Iraqi invasion of Kuwait. A revival in oil demand growth rates in the industrialized world between 1988 and 1990, partly aided by several years of low oil prices and double-digit annual consumption growth in the newly industrializing countries of East Asia, gave OPEC the chance to induce price increases above US$18 per barrel. Some members called for expanding OPEC's overall output ceiling by a smaller factor than the growth in anticipated demand, which would in effect push oil prices up, possibly back to their early 1980s level.

Whereas Saudi Arabia has always endeavored to maintain moderate oil prices, regional political and economic concerns have also motivated the kingdom not to depress prices too far, the 1986 Saudi-induced price crash notwithstanding. In 1988 and 1989, King Fahd publicly guaranteed that Saudi Arabia would work to achieve oil price stability at US$18 per barrel. There was one overwhelming reason for this policy: with the Iran-Iraq War cease-fire in 1988, the kingdom wanted to maintain oil prices at levels that would force Saddam Husayn to be concerned with rebuilding Iraq rather than threatening his neighbors. This objective was formally registered in the 1989 Nonaggression Pact that Riyadh signed with Baghdad.

The biggest battles in OPEC prior to 1990, however, were between Saudi Arabia and two of its gulf neighbors: Kuwait and the United Arab Emirates (UAE). Both refused to restrict production to their quota levels, and by early 1990 their serious overproduction contributed to mounting international crude oil inventories. By the second quarter of 1990, the oil traders in New York were pushing oil prices down.

Saddam Husayn's envoy, Saadun Hamadi, toured the gulf in June 1990 and halted the slide in prices as Iraq unveiled its own "oil weapon": the threat to invade Kuwait. Buttressing this threat by mobilizing 30,000 troops on the Kuwaiti border, Baghdad dictated an agreement at the OPEC ministerial meeting the following month. Although respecting Saudi Arabia's 25 percent market share, and allowing the UAE to raise its quota to 1.5 million barrels per day, OPEC set an overall ceiling of almost 22.5 million bpd and a compromise price of US$21 per barrel.

Saudi Arabia played a largely passive role at the July 1990 OPEC meeting in Geneva and conceded to Iraq's bid for dominance. Kuwait was clearly cowed: even before the meeting it reduced its oil output and appointed a new oil minister, Rashid Salim al Amiri, an unknown chemistry professor, to replace Ali Khalifa, the architect of Kuwait's downstream projects and its aggressive oil policies.

When Iraq invaded the invasion of Kuwait, it provoked massive intervention by the United States into the gulf and ultimately lost its power within OPEC. Behind direct United States protection, the kingdom's oil production rose to 8.5 million bpd or 35 percent of OPEC's total output.

Operation Desert Storm allowed Riyadh to regain its status within OPEC. At each successive OPEC meeting until the gathering of ministers in February 1992, Saudi Arabia dictated the final agreements with virtually no opposition. The eleven active members were producing at capacity while prices remained relatively high. Between March and July 1991, both Iran and Saudi Arabia expertly sequenced the unloading of large stocks of oil in "floating storage," which had been built up as insurance during Operation Desert Shield, and prevented an anticipated crash in oil prices during the spring and summer months of 1991. Part of the harmony within OPEC resulted from the opportunity Iran saw in being more cooperative with Saudi Arabia. For the West to see Iran as a "responsible" member of OPEC could help attract investment for its oil and other industrial sectors.

Observers of OPEC, however, awaited the revival of the old dove-hawk battles. The February 12, 1992 OPEC meeting was held to discuss reinstatement of the July 1990 agreement, temporarily suspended after August 2, 1990. The hawks wanted to preserve the quota system and the reference price, which had been neglected in order to replace lost Iraqi and Kuwaiti output, pushing oil prices to about US$21 per barrel for the OPEC basket. The expected return of Kuwait and Iraq to the oil market required a return to the preinvasion rules if prices were not to fall sharply.

Saudi Arabia's aim at the February 1992 OPEC meeting was to eradicate the last vestiges of the 1990 agreement and its quota shares, especially the kingdom's share of about 25 percent. At the February 1992 meeting, OPEC members refused to blink at Saudi pressure. Iran particularly was willing to risk the improved relations it had forged with Saudi Arabia and absorb the oil price cut.

Saudi Arabia's income requirement in the wake of the Gulf War would, Tehran suspected, keep the Saudis from forcing other OPEC members into accepting its objectives as it did in 1986. Technically, the final agreement reached was essentially what the Saudis wanted in the short run: a total production ceiling of almost 23 million bpd and a temporary quota of 35 percent of the ceiling and the maintenance of price stability. They did not achieve their long-term objective: unanimous OPEC recognition of a 35 percent market share of all future OPEC output ceilings.

Longer-term Saudi policy imperatives for the 1990s were shaped by structural factors within OPEC and within the international oil market. Highest on the priority list was the decision to push domestic oil capacity to more than 105 million bpd sustainable capacity with a further 1.5 million to 2 million bpd surge capacity in times of emergency. Three factors prompted these expansion plans. Growth in world demand for oil over the preceding several years, combined with the Persian Gulf War, had pushed the kingdom and other OPEC countries to their production capacities. Expecting that demand would continue to grow and that most other exporters were constrained by diminishing oil reserves or financing problems, a rapid rise in capacity could capture any increase in demand that might occur. Second, in light of the post-1986 intra-OPEC market-share competition, oil capacity expansions have had a direct impact on the ability of individual members to jockey for quota increases. Third, the ability to raise output at will, in the event of an unforeseen price decline, helped stabilize total oil revenues, which constituted the bulk of domestic budgetary income.

Saudi Arabia's interest in moving downstream was also a priority of its oil policy. The drive to obtain overseas refining and storage facilities was designed to further two objectives related to security of supply. First, the kingdom wanted to obtain captive buyers of its crude, assuring stable prices and terms. Saudi Arabia would thus be more receptive to market conditions in consuming countries and avoid being closed out of certain countries. Gaining further profits from refining the crude was an associated reason for the move downstream overseas. Second, the kingdom sought to provide consuming countries with "reciprocal security measures," under which it would undertake to guarantee supply--through capacity additions or stocking arrangements abroad--in return for consumer countries' decisions to avoid taxes and import restrictions on oil. Few consuming countries, however, have responded favorably to such arrangements.

Data as of December 1992

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