Abstract
This study is systematic research into justifying the strategy that Saudi Arabia should adopt to maintain stability despite competing fluctuations in oil prices and shrinking market size. The fundamental principles of macroeconomics of demand and supply fail to justify how reducing production quotas could drive up prices and increase revenue without other noise variables.
Empirical evidence shows that the price of oil has constantly varied due to different market condition that is either driven by demand due to an improvement of the global economy, contribution of political factors such as an economic embargo on oil, reduction in production due to the implementation of OPEC’s production quotas, political turmoil such as in Iraq and Iran or as a result of simply low quantities.
Reducing the quantity does not justify an increase in price because of evidence of loss of significant size of Saudi Arabia’s traditional customers such as South Korea, leading to shrinkage in the market size. Because of the unpredictable effects of other variables on the price of oil besides a reduction in quantities, it is imperative for Saudi Arabia to focus on maintaining its market share, which is difficult to establish and adopt a market-driven pricing mechanism.
Introduction
The grim economic outlook because of low oil prices has caused a $146bn deficit in Saudi Arabia’s budget from a projected expenditure of $313bn (Alzomaia & Al-Khadhiri, 2013). According to Barnes, and Jaffe (2006), the dilemma is to raise the price of oil that could compromise the market size because of the compelling need depicted in the 2012 and 2014 survey where Saudi Arabia demanded a 10.4% increase in expenditure to address the region’s political instability and domestic spending, which has thrust the country into a dilemma on either to choose for a reduction in production quantities or focus in maintaining the market share (Becken & Lennox, 2012).
Warning signs show that the price of oil has decreased from US$145 per barrel in July 2008 to $30 per barrel on February 3, 2016, demanding for a true strategy to adopt (Mănescu & Nuño, 2015). A decrease in the production levels has direct effects of an increase in oil prices (MacKenzie, 1996). For instance, the price of oil was raised from $14 in 1978 to $35 in 1981 due to a significant reduction of 2 to 2.5 million barrels of oil per day between November of 1978 and June of 1979.
However, relying on sound macroeconomic principles of demand and supply cannot justify a decrease the quantities of the supply side to establish the desired equilibrium with the demand side as a solution to raise the price of oil (Magdoff, 2013) 1973, 1979, 1990 and 2008 trend provided false hope because of the subsequent recession, decrease in demand, and ultimate decrease in Saudi Arabia’s market size (Malik & Awadallah, 2013). It is natural to raise the question of if Saudi Arabia should decrease the quantity of oil production to raise the prices or focus on maintaining its market share?
Main Body
According to Lippi and Nobili (2012), the grim economic forecasts show Saudi Arabia’s fiscal deficits leads to the question of if the largest producer of oil should reduce the quantity of oil it pumps into the global to increase the prices of oil to address its fiscal deficits, which could consequently scare away customers who could seek for alternative sources of oil or concentrate on maintaining its share of the market.
Saudi Arabia, which is the largest producer of oil, holds the key to the stabilization of the prices by reducing the quantity of oil it pumps into the market (Lipietz, 2013). The price of oil cannot be determined by Saudi Arabia alone compelling the need to maintain the market share and leave other market forces to determine the oil prices. Reducing the quantity of oil could cause a decrease in the supply of oil in the market and in theory to increase the prices, which could subsequently shrink the size of the market.
A review by Lahn and Preston (2013) shows that the rapid increases in the prices of oil between 1973 and 2008 in response to the macroeconomic principle of demand and supply do not sustain evidence of steady market price levels because of the subsequent decreases in demand. However, the refusal by Saudi Arabia to reduce the quantity of oil pumped into the market has enabled the country to maintain its market share without the benefit of an increase in the price of oil, which, in 2016 has stagnated at $30 per barrel. According to the discourse by Kjärstad and Johnsson (2007), reducing the quantity of oil Saudi Arabia into the global market cause a temporary increase in the price of oil, but subsequently results in the reduction of the market share as customers seek for cheaper sources of oil.
The mechanism of decreasing the quantity of oil supplied into the market is embedded in classical economic reasoning but fails to consider other forces (Kilian, 2008). The increasing number of oil-producing countries joining the oil market, better oil extraction technologies, cheaper extraction methods of oil from oil shale, and political reasoning could counter the effects of quantity vs. demand and its correlation with oil prices (Keohane & Victor, 2013). The main idea of reducing production in the short term can be in favor of Saudi Arabia as evidence of the price increases showed between 1979 and 980 and positive demand forecasts (Gholz & Press, 2010).
However, a careful survey shows that demand was partially accelerated by the rapid growth in the global economy including that of China, which is now in recession (Harstad, 2012). Political instability such as the Korean War of 1951-1953 caused an increase from $17 to $20 (Colgan, 2014). That is beside the Arab oil embargo of 1973, the 1979 Iranian Revolution, and the insulation period that caused the oil to peak at $103.76 in April 1980 (Finley, 2012). That is so despite the argument that the price of oil depends on demand and supply.
The increase in demand for oil and consequent rising of prices does not reflect the true nature of the effects of quantity on demand and supply (Esper, Ellinger, Stank, Flint, & Moon, 2010). Examples include the oil glut of the 1980s, which statistically justify diverse contributing factors for the decrease in price from US$35 per barrel ($101 per barrel today) to $10 ($58 to $22 today) inflation-adjusted (Smith, 2009). That is despite the low production quantities and weakening demand because of a slowing down of the economic growth of industrialized countries such as Japan (13% reductions) and global economic recession (Finon & Locatelli, 2008).
The temporal rise in price that stabilized at around $18 per barrel between 1987 and 1989 was due to a strong US economy and booming Asian markets and a reduction of OPEC’s production quotas of 3 million barrels per day (Nuruzzaman, 2013). An increase in oil prices was additionally due to an increase in colder conditions in the Northern Hemisphere between 2010 and 2012 (Painter, 2012). In theory, the cycle that governs the behavior of commodity prices occurs every 29 years, which excludes Saudi Arabia from the presumption of a correlation between quantity and pricing.
An interpretation of the discourse on the factors that compel Saudi Arabia not to concentrate on adjusting the quantities of oil downwards to raise the price is unjustifiable (Tverberg, 2012). Instead, focusing on maintaining the market share justifies the latter against the former as the oil cycle peaks besides decreases that occur in a regular pattern of a 29 years cycle (Tabrizi & Santini, 2012). Between 1950 and 1960, the price of oil was $1.71 and $2.0 with relative stability (Suganthi & Samuel, 2012).
After the establishment of OPEC, prices were controlled by production quotas, which experienced steady growth, obeying the economic principles of demand and supply. Steeper cuts in production were counterproductive, causing a weakening in demand and the global economic recession that led caused the 1973 – 1977 oil shock (Hirsch, Bezdek, & Wendling, 2010). Other events such as the Iran/Iraq war caused an increase in oil prices despite the 1983 – 1995 oil shock that led to low oil prices. It is evident that low production quotas set by OPEC achieved mixed results (Stern, 2007). A subsequent economic crisis led to a decrease in oil prices, necessitating Saudi Arabia to revise its strategy of focusing on maintaining its market share.
Having proved that elasticity of demand and supply cannot be controlled by limiting Saudi Arabia’s production quotas without creating a gap for competitors to invade its market (Greenwood‐Nimmo, Nguyen, & Shin, 2012). It is imperative to investigate a countermeasure that could uphold the country’s market position (Al-Saleh, 2009). The unsteady fluctuations of oil prices due to external variables of economic growth and decline mixed with controlled production quotas are a big indicator of false hope and reliance on quantity controlled prices (Barnes & Jaffe, 2006).
Temporary gains such as happened in the earlier 1950s do not reflect consistent with the law of demand and supply (Bielecki, 2002). That done, it dismisses the reliance of pricing on production quotas that were introduced by OPEC as prices tended to decrease, which led to the oil shock of 1978 – 1982 (Brémond, Hache, & Mignon, 2012). That is when the price of oil plummeted from $11.58 to $14.02 per barrel before the subsequent increases and decreases, showing a variation of around $ 25 in August 2003 and $130 in mid-2008 before the fall in subsequent years (Bremmer, 2009). Market conditions dictated the behavior of the market not only including the quantity of oil but political.
Among the solutions that researchers recommended is to maintain the market share to cushion Saudi Arabia from the effects of unstable oil prices (Morse & Richard, 2002). That is due to competition from oil-producing countries such as Russia and Iran, and the production of oil from oil shale in the United States (Verbruggen & Van de Graaf, 2013). The rationale of focusing on maintaining its market share is propped by the reasoning that many countries such as South Africa have significantly reduced their purchase of oil from Saudi Arabia from almost 53 percent to 22 percent (Knox-Hayes, Brown, Sovacool, & Wang, 2013).
Besides the reduction in imports by the USA, which fell from 17 percent to almost 14 perdue to the local production of oil from oil shale (Tang & Xiong, 2012)? Other countries where Saudi Arabia has lost market include several western European countries including South Korea, Thailand, and Taiwan (Robertson, Al-Angari, & Al-Alsheikh, 2012). The alarming shrinkage of the country’s global oil market coupled with the decrease in the price of oil has necessitated the country to continue working towards preserving its market instead of reducing production quantities, resulting in a significant revenue reduction.
Besides, the revenue from the sale of oil has reduced significantly because of the coupling effect of the reduction in the price of oil and market size (Abbaszadeh, Maleki, Alipour, & Maman, 2013). According to Basher, Haug, and Sadorsky (2012), the problem with the price of oil is not as persistent as the problem associated with the shrinkage in the size of the market. The rationale is that prices can increase as noted earlier based on the market and economic conditions such as wars, economic sanctions, and the effects of the economic principles of demand and supply (Cairns & Calfucura, 2012).
Strong indicators that oil prices can always rebound is in response to the factors of demand and supply (Colgan, Keohane & Van de Graaf, 2012). That caused the variations that occurred between 1950 and 2016 (McNally & Levi, 2011). Within the spans of many years, it is evident that oil prices increased such as the oil shock of 1973 (Gabbasa, Sopian, Yaakob, Zonooz, Fudholi, & Asim, 2013). The post-1973 price increases, despite the subsequent years of energy efficiency, led to an increase in the price of oil, but the subsequent global recession and a decrease in the price of oil.
Conclusion
Facts that attest to the need for Saudi Arabia to focus on maintaining its share of the market while keeping its oil production quotas steady has been strongly supported by empirical evidence due to the uncertainty of the global oil market despite the shrinking revenue due to the dynamic market conditions. The economic principles of demand and supply do not exhaustively justify the reduction in production quotas to increase demand and raise the price of oil. Research has shown that despite the constant level of fluctuations and oil shocks, there is no steady-state that could be justified by a reduction in production quantities.
The market size is a strong factor and indicator of the revenue generated because it responds to various factors besides market share, price increases, and better forecasts. That is true of the trend that has been observed since 1973. Post-1973 prices, the effects of OPEC interventions that recommended for production quotas, the low oil prices of 1986 to about 2002, increase in oil prices 2002 in 2002 and onwards, and a slow in demand for oil. That leaves Saudi Arabia with the question of why the traditional markets are seeking alternative sources of oil.
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