Last week, a former Saudi oil minister put an estimate on what big-time unrest in Saudi Arabia might mean to world oil prices:

"If something happens in Saudi Arabia it will go to $200 to $300. I don't expect this for the time being, but who would have expected Tunisia?" [Sheikh Zaki] Yamani told Reuters on the sidelines of a conference of the Centre for Global Energy Studies (CGES) which he chairs.

Which got me thinking. What would be the fundamental price implication of "losing" all of Saudi Arabia's oil? What if unrest there totally shut down output for the foresable future? What kind of oil market Armageddon would result?

My surprising calculation? Oil at $150 per barrel, then perhaps retreating to $125 per barrel.

Unbelieveably modest? That was my initial reaction -- but I'm coming around.

Here's the math behind my couldn't-be-simplier model:

- Current "steady state" world oil price of $100/bbl, that is, the price sans temporary "risk premium." (Many market watchers consider that level to be lower, more like $75-$90/bbl.
- Current Saudi production of 10 mm bbl/day, out of a world total of 84 mm bbl/day, or 12%
- Short term consumption elasticity of -0.25, that is, if oil prices climb 10%, consumption declines 2.5%.

So the math we need is simply to calculate the price increase over $100 per barrel required to reduce consumption by 12% and thereby keep quantity demanded in line with quantity supplied. This is: $100 bbl + (-12% /- 0.25) *$100 bbl = $148. Lets call it $150 per bbl.

Some studies suggest that the long term (multiple years) price elasticity for oil is -0.5 or better, meaning that instead of +$50 over todays price, the long term effect of losing 12% production is about half that, or $125/bbl.

I'm simplifiying a vast array of real world complexities, and our reality post-SA could be worse. A deeply alarmed industrial world could cause a real risk premium of any almost any amount, for a while. A world growing with population and (presumably) income will continue to push up the demand curve moving forward. World demand may be higher now than in the recently measured past, which included a recession. And Saudi Arabia has an even higher share of world reserves than its share of production.

On the other hand, permanently higher prices will also induce more exploration and production outside Saudi. And a risk premium cannot exist indefinately.

Another way to examine the issue is to ask: What would the price elasticity need to be to achieve a price of $250 bbl -- the midpoint of Mr. Yamani's estimate? That would be 0.08. More intuitively it equals an* increase* of $3.50 per gallon of fuel (so, in the U.S., gas >$7) to get consumers to use 12% less. That price increment strikes me as far more than what would be needed to see this level of reduction.

I'm comforted by these calculations, but would prefer not to see the experiment run.

Kelly,

I am curious. Based on an elasticity of -.25 in the short term and upwards of -.6 in the long term what have been the actual consumption rates in the US over the past 2-3 years, where we have seen a prolonged realtive price increase greater than 10-12%? How accurate has this index been?

Posted by: John Kramer | 05/27/2011 at 01:19 PM