Last month, a significant drop in Brent crude prices came after Saudi Arabia and other OPEC Plus members announced their first reductions in four years, marking the second consecutive year for this action. Many may interpret this as an effort to appease President Trump, who has emphasized the need for cheaper oil for his supporters. He has even lauded the Saudi crown prince as an “Incredible Man.” However, others may view this move as a strategic mistake. Both interpretations might oversimplify a complex situation.
To understand the reasons behind this, it’s helpful to look back to 2020.
Real-time satellite monitoring revealed that the world’s capacity to store crude oil was rapidly diminishing. Initially, the decline in demand was exacerbated by the Covid-19 pandemic and subsequent lockdowns. Shortly after these restrictions took effect, Saudi Arabia and Russia began what many considered to be an ill-fated oil price war. Although it appeared to be a major misstep at the time, there might have been a broader strategy at play.
Using game theory, my team, which includes Fields Medal recipients Pierre Louis Lions and Jean-Michel Laslie, developed a model that clarified how major producers like Saudi Arabia could maximize profits. The key was finding the balance between selling at the highest price and maintaining a substantial market share.
While OPEC claims to stabilize prices, in reality, the market fluctuates quite a bit. When prices rise, larger players earn more, but smaller, higher-cost producers may be incentivized to increase output to maintain cash flow.
Major oil producers are well aware of this. After allowing smaller competitors to increase production, they often flood the market to drive prices down intentionally. This strategy aims to squeeze out weaker competitors, which can lead to more significant market share for the dominant players.
The price decline driven by reduced oil demand during the pandemic has been unprecedented. Both Russia and Saudi Arabia seized the opportunity to test how much oil the world could physically store. When inventories maxed out, prices even dipped into negative territory. Many US shale operations went bankrupt, leaving Saudi Arabia and Russia in a stronger position within the oil market.
Typically, price crashes need a triggering event. In 2020, it was Covid-19, but similar instances occurred during the late 1990s due to the Asian financial crisis and during the 2014-2016 period in tandem with the US shale boom. Currently, US policies appear to be another catalyst for volatility. With US oil production on the rise and smaller OPEC Plus members unable to meet quotas, Saudi Arabia seems poised to take decisive action again. The model we developed indicates that the temporary pain could be worth it for Saudi Arabia to secure market dominance and deal with its smaller competitors.
What sets this situation apart is Trump’s active request for OPEC to increase supply. This could fulfill the American public’s demand for lower oil prices. Essentially, he may have inadvertently granted Saudi Arabia the freedom to drive the market down. If oil prices continue to drop, US companies might have to cut back on production and could struggle to survive prolonged periods of low prices. There’s a risk that if the market expects a rally or even stability, they might be left disappointed.
Ultimately, Saudi Arabia, the seasoned master of the oil landscape, is well-positioned to shape the market to its advantage in the long run.
