Saudi Arabia”s position as one of the largest players in the global oil market, producing more than a tenth of the world”s output and owning a quarter of the world”s proven reserves, has negative effects on other market participants. Writing in the December 2013 issue of the Economic Journal, Anton Nakov and Galo Nuño document two features that have made the Kingdom different from other oil producers:
· First, it systematically restricts its production. In fact, its spare capacity is much larger than the aggregate spare capacity of the rest of the world”s oil producers.
· Second, its production is quite volatile. The variance of Saudi oil output has been very high compared with that of the other producers, even though the Kingdom itself has witnessed few domestic shocks affecting oil production directly.
The Kingdom is a key member of OPEC (Organization of Petroleum Exporting Countries), playing a central role in its decision-making. Indeed, some economists have argued that ”OPEC is Saudi Arabia” and that ”the Saudis have acted as what they are: the leading firm in the world oil market”. Are these claims exaggerations?
Nakov and Nuño show that it is possible to explain the behaviour of Saudi Arabia as that of a dominant producer operating alongside a competitive fringe. They build an analytical model in which a dominant oil supplier anticipates the behaviour of both fringe oil producers and oil consumers.
This means that Saudi Arabia exploits the fact that its operations affect the supply of fringe producers, oil demand and the oil price. The result is that Saudi Arabia produces a smaller amount of oil than its capacity given the oil price, which allows it to charge a high mark-up over its marginal cost.
The authors use their model to explain a particular episode during the first Persian Gulf War. The model reproduces well the more than 50% jump in the output of Saudi Arabia in response to the combined output collapse of Iraq and Kuwait.
According to the model, this behaviour of Saudi Arabia is entirely consistent with its own profit-maximising objective, as opposed to alternative non-economic considerations. When fringe oil producers are hit by a negative shock, it is optimal for the dominant supplier to increase its output substantially, but not so much as to offset fully the output collapse of the fringe – with the result that the oil price is allowed to rise in tandem with oil sales.
The existence of a dominant supplier with monopolistic power has negative effects on other oil market participants. In particular, Nakov and Nuño show that the dominant oil producer extracts monopolistic rents from the competitive fringe.
This suggests the desirability of a subsidy to oil production by the fringe. The authors find that the optimal subsidy to fringe production is such that the oil price mark-up is completely eliminated and the oil price is significantly reduced.
”Saudi Arabia and the Oil Market” by Anton Nakov and Galo Nuño is published in the December 2013 issue of the Economic Journal. Anton Nakov is currently Staff Economist at the Bank of Spain. Galo Nuño is currently Economist at the European Central Bank.
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