Oil above one hundred dollars, a new normal for the West?

In the oil world, there is not a single price. The financial market focuses on Brent and WTI, traded in London and New York, respectively. Today, they suggest a price fluctuating around $90 per barrel. However, from the perspective of Saudi Arabia, for example, oil is already reaching $100.

This price difference reflects the pricing power that Saudi Arabia has gained over the past year and a half. This has allowed Riyadh to charge a record price for its oil, especially to American and European customers looking for alternatives to Russian crude.
The surcharge is significant due to Saudi Arabia’s central role in the market, producing approximately one of every ten barrels worldwide. Riyadh’s pricing strategy fuels global inflationary pressures, potentially forcing central banks to maintain higher interest rates for longer. At the same time, Riyadh’s geopolitical influence is strengthening.

On Wednesday, Saudi Arabia’s flagship oil price, the Arab Light, reached nearly $98.47 per barrel in Europe. Over the past 40 years, Arab Light has traded above $100 only a few times: in 2008, between 2012 and 2014, and in 2022.
Markets have set the prices since the collapse of the fixed oil price system administered by the Organization of the Petroleum Exporting Countries in the mid-1980s. The OPEC’s influence lay in production adjustments. Since 1988, Saudi Arabia has sold its crude through long-term contracts based on a formula that combines a benchmark index, such as Brent, and a relatively small discount or premium. The benchmark and differential vary depending on whether sales are made to the Americas, Europe, or Asia.

For most of the last 35 years, these differentials were measured in cents rather than dollars. Except for Asia, they were mostly negative, meaning Riyadh sold its crude at a lower price than European and American benchmarks. Asia paid a premium, but it was relatively small. Between 2000 and 2020, the kingdom charged European buyers an average discount of about $3 per barrel compared to Brent. More recently, it has imposed a premium that has steadily increased. For September, Saudi Arabia set the price of Arab Light at a record level of $5.80 per barrel, more than Brent. For American consumers, this premium also reached a record of nearly $7.25 per barrel. The premium for Asia is currently lower, although it came to a record of nearly $10 last year.

Saudi Arabia’s regained pricing power is due to two factors. The first, and perhaps most important, is that Riyadh is taking a share of the profits oil refiners enjoy. Worldwide, refining margins, the difference between the cost of crude oil and the value of gasoline, diesel, and other petroleum products, have reached record levels due to high demand and a lack of refining capacity.
Each month, Riyadh calculates the value of the products a typical refinery would produce by processing Saudi crude, known in the industry as the Gross Product Worth, or GPW. The higher the GPW, the more a seller can charge a refinery without the buyer complaining. Since mid-2022, the GPW of a barrel of Saudi crude has surged. Thus, the kingdom ensures that refiners share in some of these additional profits.

The second factor is that the global oil market needs the type of crude oil produced by Saudi Arabia. This is mainly the result of significant production cuts implemented by the kingdom this year. But it also reflects that the largest source of additional oil supply, U.S. shale, is very different from Saudi crude. Saudi crude is a staple for many refiners with state-of-the-art facilities capable of cracking the most challenging hydrocarbon molecules, allowing them to run their plants more efficiently. This is particularly beneficial for diesel, the workhorse of the global economy. In contrast, U.S. shale oil produces comparatively more petrochemical products.

Another crucial element has unfolded in an unsettling Western calm: the announcement of the BRICS. Iran, Saudi Arabia, and Russia will be in the same alliance, which, before the war in Ukraine, accounted for a third of global production. Add China, which does not export but produces approximately 5% of the global output. Also, even if they are not in the initial version of BRICS, the United Arab Emirates are very close to Saudi positions and represents 4% of global production. The potential to disrupt Western economies is enormous, predisposing oil prices to remain high.

The major fluctuations in oil prices over the last decade have all been driven by geopolitics, not supply and demand forces in international financial markets. In 2014, OPEC’s cartel discipline collapsed, widely seen as an attempt to punish shale operators by reducing crude oil prices to a level where they could no longer operate profitably. In 2020, another rift reflected the dispute between Saudi Arabia and Russia. And the invasion of Ukraine triggered the increase in oil prices at the beginning of last year.

The latest rebound is also mainly due to geopolitics, this time a new “iron alliance” between Saudi Arabia and Russia. The United States responded to last year’s price surge by tapping into its strategic oil reserves, which were established precisely for such moments. This prevented Russia from holding the Western world hostage over oil prices. But having done it once, the United States cannot deplete its reserves anymore.

The deterioration in relations between the United States and the Saudi Kingdom began under the Obama administration, worsened under the Trump administration, and definitively unravelled under the Biden administration. As a reminder, the U.S. President’s summer visit to Riyadh in the summer of 2022 yielded only meagre results and was described as humiliating for the United States.

Rather than trying to explain the price of oil by referencing demand (which is currently rising) and supply, it is better to consider the latest Saudi alliance as what economists call an exogenous event likely to shock the rest of the global economy and finance.
More importantly, the rise in oil prices acts as a tax increase, depriving consumers and businesses of money and depressing demand. Increases in heating or gasoline prices are immediately visible and highly politically sensitive.” The party has just started regarding the new alliance in the BRICS and the united position of China-Russia-Iran, and Saoudi Arabia on the West.

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