Why the Saudis Are Cutting Oil Prices By Dr. Kent Moors

In 280-279 B.C., the Epirian King Pyrrhus defeated the Romans in two consecutive battles. But he suffered such a large number of casualties that his army could no longer carry on the fight.

Ever since then, the term "Pyrrhic victory" has become synonymous with winning at too high a cost.

These days some are beginning to wonder if the Saudis are marching down the same road.

By cutting oil prices rather than export volume, Saudi Arabia has signaled it is now ready for a potentially costly price war...

On Oct. 1, Saudi Aramco, the state-run oil producer of the world's biggest exporter, cut prices for all its exports, reducing prices for Asia to the lowest level since 2008.

The so-called "Asian premium" I have talked about on several occasions - the higher price Asian importers need to pay over other end users for the same consignment of Saudi crude - is still there, but it has been reduced significantly.

What appears to be quickly forming is a situation that parallels an earlier Saudi move back in the mid-1980s. Under much lower pricing constructions, Saudi Aramco dramatically increased its exports, thereby slashing the cost of oil.

At the time, Saudi authorities were attempting to straighten out several recalcitrant OPEC members who were selling volume in excess of their monthly quotas. Saudi Arabia has traditionally served as "the balancer" in the cartel, offsetting actions by other members in order to maintain OPEC policy.

Today, the Saudis are cutting prices for a different reason.

There appears to be a direct battle underway among OPEC members for market share in a pricing environment increasingly defined by unconventional (shale and tight) reserves.

The move suggests that the biggest member of OPEC is prepared to let prices fall rather than cede market share by paring output to clear a supply surplus, according to a comment from Commerzbank, the Frankfurt-based global banking giant.

Usually, the Saudis act in the other direction.

In the past, Saudi Arabia has acted to stop a plunge in prices.

In 2008 and 2009, the Saudis made the biggest contribution to OPEC's production cuts of almost 5 million barrels a day as demand contracted amid the financial crisis.

Today, the kingdom would need to reduce output by about 500,000 barrels a day to eliminate the supply glut caused by the highest U.S. output in three decades, according to several analysts.

Aramco reduced official selling prices, or OSPs, for all grades of crudes to all regions for November. It lowered the OSP for Arab Light to Asia by $1 a barrel to a discount of $1.05 to the average of Oman and Dubai crude, the lowest level since December 2008. OSPs are regional adjustments Aramco makes to its pricing formulas to compete against oil from other countries.

Indications are that the Saudis intend to keep output steady until the end of the year, near the 9.6 million barrels a day extracted in August and September. However, that did follow the largest Saudi cut in almost two years made in August, according to the Saudi data provided to the OPEC Secretariat in Vienna at the time.

Refraining from further cuts would preserve the volume of Saudi Arabia's oil sales, curb revenue for competitors, and discourage production of U.S. shale oil.

That's because a further decline in crude oil prices would make some production in the United States unprofitable, preserving Saudi exports at the expense of American shale operations.

At the moment, most of my contacts are of the opinion this is less a Saudi attempt to punish others (as was the case in the mid-1980s), but more of an attempt to compensate for the falling cost of Atlantic basin-sourced crude.

The decision to reduce OSPs is in line with declining crude oil prices, leading some knowledgeable observers to conclude it is no more than a "mechanical aspect; if [raw material] prices fall, customers wouldn't understand why you've maintained higher OSP," one noted.

However, this does point to a major change in the way oil is moving. For some time now, OPEC has not attempted to dictate price. That's really beyond its ability, since it controls less than 42% of the world's daily availability.

Rather, each month it calculates the global demand, subtracts volume coming from others, and then determines "the call on OPEC." That "call" is then divided among the various monthly quotas for the cartel members.

In short, this has become a supply issue.

But in the process, it has lost control over pricing power, prompting some to conclude that the Saudi moves will ultimately lead to lower prices in the longer term.

So long as the emerging pricing band is stable and in the $85- to $95-a-barrel range, the prime beneficiary may still be U.S. domestic production.

That's true whether the Saudis cut oil prices again or not.

More from Dr. Kent Moors: Something is now afoot in the Pacific Northwest that will change how we think about pricing oil - and provide a range of fantastic opportunities for investors. Make no mistake: The U.S. oil export surge is coming...