How to Lower the Price of Oil

The road to cheaper gas at the pump runs through Riyadh.

If there's one thing that unites U.S. President Barack Obama, top-ranking Saudi officials, and Americans at the gas pump, it's this: The price of oil is too damn high. What's more, given physical and market realities, this should not be so. Despite the sanctions on Iran and the threatened loss of its export production, the world has no shortage of oil.

Several oil suppliers are more than capable of picking up the slack left by Iran. U.S. and Canadian production, both actual and in the near future, is at historically high levels. And more significantly, Saudi Arabia's potential output is an unprecedented 12.5 million barrels per day.

Still, fears abound about a shortage of oil. The United States and Europe are now contemplating the extraordinary, and unnecessary, measure of releasing oil from their strategic petroleum reserves to calm markets. And in a rare and significant move, Saudi Oil Minister Ali Naimi recently published an opinion article in the Financial Times expressing frustration at his inability, through reassuring statements, to bring down the price of oil, despite its abundance and the kingdom's ability to satisfy all demand.

There is a double paradox here: The leading oil-exporting country in the world not only would like to see lower prices, it finds itself powerless to achieve the desired result. Nonetheless, the key to lowering prices lies with Saudi Arabia and, remarkably, it involves straightforward adjustments to the way oil is marketed and sold.

There is, of course, solid logic behind Saudi Arabia's ambitions to bring down oil prices. Higher prices are not in the long-term interest of producers -- they are bad news for the global economy, and destroy demand in industrial and developing countries alike. The kingdom also has political reasons to be leery of elevated prices: It is concerned that the present high price is discouraging some oil-importing countries from curtailing their purchases of Iranian oil, thereby strengthening Tehran's hand with abundant financial revenues.

Saudi Arabia is ready to increase its already high production volume further to 12.5 million barrels per day, an all-time high, and its storage facilities abroad have been filled to the brim, according to Naimi's article. It is anxious to assure international buyers that it could meet any shortfall of supplies -- for example, if Iranian oil disappeared from the market. Saudi Arabia may not want to be seen as actively undermining Iranian oil exports, but it is in fact doing just that.

So, why do oil prices remain stubbornly high? Why does the market behave irrationally and not want to listen? The reason is simply that Saudi Arabia deliberately refrains from using the market power that it might command. This is the result of past experience, when Saudi Arabia's market share and revenues suffered as a result of OPEC's aggressive price setting policy that existed before 1985. In the years prior to that date, Saudi oil production collapsed from an all-time high of 10.3 million barrels per day to a minimum of 3.6 million, in the futile attempt to defend OPEC imposed prices. Ever since that experience, Saudi Arabia has refused to be tied to a rigid price target.

As a result, Saudi Arabia is a price taker. Through press announcements and speeches, Saudi officials signal their intentions to international buyers and sellers and attempt to influence market sentiment, but the kingdom is not active as a seller on the open market. In practical terms, Saudi Arabia does not allow its oil to be traded, nor does it offer its oil without restrictions for resale. The kingdom only sells to final users -- that is, to refiners, who process the crude oil themselves. That means oil may be available, but will remain unsold if refiners do not have a demand for it.

Saudi Arabia should behave instead like a central bank that periodically conducts auctions for government paper. The interest rate -- or, in this case, the price of oil -- is then determined by the result of auctions and trading on the secondary market. Saudi Arabia, after all, is and acts like the central bank of global oil.

If Saudi Arabia allowed its crude to be traded -- that is, sold by the original buyer to some other final or intermediate client -- the abundant availability of Saudi oil would drive prices down. But the Saudis are afraid of playing an active role in the market because they do not want to be accused of "controlling" the price of oil. There is, however, a lot of ground between "controlling," at one extreme, and exercising no influence on the market on the other. It is in fact unlikely that Saudi Arabia could "control" the price even if it took a very active role in the market -- but it could certainly have an influence. Yet, the stereotype of OPEC as a monopolist intent on squeezing consumers is so deeply rooted that Saudi Arabia does not want to be seen influencing prices at all.

The United States and other leading consumers should encourage Saudi Arabia to play a more active role. A global oil market in which Saudi Arabia exerts its proper influence would be less volatile and more closely representative of the equilibrium of supply and demand. It is in our best interest that Saudi Arabia should succeed in moderating prices.

As the revival of oil and gas production in North America and in other parts of the world gains strength, it will be in the interest of all to maintain prices at a level that is neither too low nor too high. A much lower price would nip the expansion of new sources in the bud, while higher prices could abort the fragile economic recovery. Saudi price targets, which lie in a band that hovers around $100 per barrel, are not out of line with the interests of the industrial countries.

Saudi Arabia should be supported, and even urged, to be a price leader rather than a price taker. Oil prices should be discussed in the context of G-20 and other international gatherings much in the same way as interest rates or exchange rates are. No market can function well if the No. 1 supplier remains on the sidelines. Getting Saudi Arabia in the game will be good for American consumers, and bad for the mullahs in Tehran.



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