Politics & Policy

A Barrel of Bologna

The oil-price-hiking Saudis are in a defenseless position.

“Either you are with us, or you are with the terrorists,” President Bush told the U.S. Congress on September 20. It was a new paradigm that rallied not only the U.S., but democratic nations around the world. And it is a policy benchmark that should be used in judging the latest Saudi attempt to curtail OPEC oil production and raise oil prices.

#ad#Most of the global economy is in recession, and last year’s too-high oil prices were an important contributing factor. Should Saudi-dominated OPEC succeed in raising oil prices again, then recovery hopes for next year would be dashed. More, the worldwide coalition against terrorism would be weakened.

Saudi oil minister Ali al-Naimi says that the oil market has entered a “crisis mode.” He has repeatedly referred to what would, in fact, be a worst-case scenario in oil pricing for oil producers: $10 a barrel. Of course, consumers would benefit from such pricing, but this number would also halt new energy investment and production. Regardless, very few oil players believe that $10 a barrel is likely to happen. In fact, most oil analysts believe that prices in the mid- to high-teens are more likely.

What the Saudis prefer, however, is barrel pricing in the $22 to $28 range. And this is nothing short of highway robbery.

Today’s barrel price for oil is $17, which looks to be just about right in terms of two economic models of oil-price behavior. First, the inflation-adjusted real price of oil has averaged $21.50 a barrel over the past decade. Real prices moved temporarily to $45 during the Persian Gulf War, and briefly fell to $10 a barrel in late 1998 during the global financial crisis that threatened world deflation and recession. The most recent spike was slightly above $30 a barrel this year, so a $17 barrel of oil averages nicely within this pattern.

Second, the monetary model of oil prices that uses the ratio between gold and oil suggests that today’s $17 per barrel spot price (or current price) for West Texas crude is also just about right. Gold is a useful benchmark because its monetary purchasing power is relatively constant over long periods of time. Hence, over time, an ounce of gold should buy roughly the same number of barrels of oil. In the past decade an ounce of gold bought seventeen barrels of oil, on average. Today, with gold at $275 per ounce, a $17 barrel of oil implies 16.2 barrels per gold ounce. This is actually below the average of seventeen oil barrels per ounce of gold registered over the past ten years. Therefore, a $16 per barrel oil price would be consistent with the decade-long trend.

Such indicators reveal that the price-hiking Saudis are not only wrong, but flagrantly non-cooperative during this time of war and international crisis. Their behavior stands in stark contrast to the actions of Mexico and Russia, which refuse to play ball with OPEC. Spokesmen for each of these non-OPEC oil producers explicitly referred to the need for political and economic cooperation with the U.S.-led war against terrorism as a reason for not following OPEC’s lead and initiating oil-price hikes. Naturally, Mexico and Russia have their own commercial interests to look after. Increasing their share of the world oil market clearly motivates their thinking. But a political willingness to work with the U.S. is no small factor in their decision. It’s a welcome decision — and one the Saudis ought to make as well.

Certainly, the Saudis won’t go broke if the world market oil price remains where it is. In West Texas, production costs have dropped to the $6 to $10 range for a barrel of oil. In Saudi Arabia’s repressed economy, the marginal cost of oil production is estimated to be only $2 to $3 a barrel. So, there’s plenty of profit in a $17 barrel. If the Saudi’s got their asking price of $25, they’d give gouging a new name.

Today’s oil prices are about 40% below the inflated level of a year ago, and most economists believe the tax-cut effect of lower energy costs will promote world recovery next year. However, a near 50% oil hike, as proposed by the Saudi-run OPEC, will sink recovery hopes. Whose side in the battle against terrorism are the Saudis really on?

Larry Kudlow — Larry Kudlow is CNBC’s senior contributor. His new book is JFK and the Reagan Revolution: A Secret History of American Prosperity, written with Brian Domitrovic.

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