The Number That Runs the World

It's Monday, March thirtieth, and welcome to HigherIQ. A couple of weeks ago we talked about the Strait of Hormuz and what happens when a chokepoint for twenty percent of the world's oil supply gets threatened. A few of you asked a simpler question: how does the price of oil actually get set? Who decides what a barrel costs, and why does it seem to change every day? The answer involves a number that most people have never heard of, a cartel that can't stop cheating on its own rules, and two price wars launched by the same country for the same reason, both of which failed. A barrel of oil is forty two US gallons, a standard set in the 1860s when Pennsylvania producers shipped crude in wooden whiskey barrels. The size stuck. The global oil industry still prices trillions of dollars of trade around a unit of measurement borrowed from the liquor business. But when you hear "the price of oil" on the news, you're almost never hearing what someone actually paid for a barrel that day. You're hearing the price of a futures contract, a financial agreement to buy oil at a set price on a future date. The two benchmarks that matter are Brent crude, named after an oil field in the North Sea and traded on the Intercontinental Exchange in London, and West Texas Intermediate, or WTI, traded on the New York Mercantile Exchange and priced at a storage hub in Cushing, Oklahoma. Brent is the international benchmark. About eighty percent of the world's oil trade is priced relative to it. WTI is the US benchmark. Historically, Brent trades a few dollars higher than WTI. Most people assume oil prices are set by supply and demand, and at the broadest level that's true. But the more useful way to think about it is that every oil-producing country has a number it needs the price to be at, and those numbers are in direct tension with each other. That number is called the fiscal breakeven price. It's the minimum price per barrel a country needs to balance its government budget. Below that number, the country runs a deficit. Above it, the government is flush. Saudi Arabia's fiscal breakeven is roughly ninety four dollars a barrel, according to Bloomberg Economics. That number climbs to about a hundred and eleven dollars when you include spending by the Public Investment Fund, the sovereign wealth fund that's funding Vision 2030, the kingdom's plan to diversify its economy away from oil. Russia's fiscal breakeven is around seventy seven dollars, though its external breakeven, the price needed just to cover extraction costs, is about forty one dollars, one of the lowest in the world. The UAE sits at about fifty seven dollars. Iran, Iraq, and Algeria all need prices above ninety nine dollars. And US shale producers, depending on the basin, break even somewhere between forty five and sixty dollars. These numbers explain almost everything about how oil-producing countries behave. Saudi Arabia wants prices high enough to fund its transformation into a post-oil economy but low enough to prevent US shale from eating its market share. Russia needs prices high enough to fund military spending but can tolerate lower prices longer because its extraction costs are so cheap. The United States wants prices low enough to keep consumers happy but high enough that domestic producers keep drilling and hiring. The institution that tries to manage all of this is OPEC, the Organization of the Petroleum Exporting Countries, founded in 1960. Together with Russia and a few other non-member partners in an arrangement called OPEC+, the group controls roughly forty percent of global oil production. OPEC's basic mechanism is simple: member countries agree to production quotas designed to keep supply tight enough that prices stay in a range the group finds acceptable. When prices drop, they cut production. When prices rise too high, they increase it. The problem is that every member has an incentive to cheat. If Saudi Arabia cuts production by a million barrels a day to prop up prices, and Iraq quietly produces above its quota to capture the higher price, Iraq benefits and Saudi Arabia pays the cost. This happens constantly. Cheating on OPEC quotas is so routine that analysts build it into their models. The cartel functions less like a disciplined organization and more like a group of rivals who periodically agree to stop undercutting each other, then immediately start again. When the cheating gets bad enough, or when outside competition gets threatening enough, Saudi Arabia has a weapon that nobody else can match: spare capacity. The kingdom can increase production by roughly two to three million barrels per day almost overnight. No other country on Earth can do that. And twice in the last decade, Saudi Arabia has used that weapon to crash the oil market on purpose. The first time was in November 2014. US shale production had been surging, and OPEC's market share was shrinking. At its November meeting, OPEC decided not to cut production despite falling prices. The Saudi oil minister made the strategy explicit: high-efficiency producers, meaning Saudi Arabia, deserve market share. The price of oil fell from about a hundred dollars a barrel to twenty seven dollars by early 2016. The logic was straightforward: US shale producers had breakeven costs around seventy dollars at the time. If Saudi Arabia could keep prices below that number long enough, shale companies would go bankrupt and exit the market. It didn't work. Dozens of shale companies did go bankrupt, and hundreds of thousands of workers lost their jobs. But the survivors got more efficient. They drilled longer lateral wells, managed fracking stages more precisely, and cut costs so aggressively that their breakeven dropped from seventy dollars to around forty five. The US shale industry came back stronger. Meanwhile, Saudi Arabia ran a record budget deficit of ninety eight billion dollars in 2015 and burned through at least two hundred and fifty billion in foreign exchange reserves. OPEC members collectively lost an estimated four hundred and fifty billion dollars in revenue during the price war. Saudi Arabia tried the same strategy again in March 2020. Russia refused to join OPEC's proposed production cuts in response to collapsing demand from COVID. Saudi Arabia retaliated by opening the taps, slashing prices, and flooding the market. Oil prices fell to twenty dollars. Then, on April twentieth, 2020, something happened that had never occurred in the history of the oil market: the price of WTI went negative. Traders who held futures contracts for May delivery couldn't find anywhere to store the oil and were paying others to take it off their hands. The price hit negative thirty seven dollars and sixty three cents per barrel. Both price wars were launched for the same reason: to kill higher-cost competitors. Both failed for the same reason: shale producers adapted faster than Saudi Arabia expected, and the financial pain of low prices hurt Saudi Arabia's own budget more than its leaders anticipated. Right now, Brent crude is trading around sixty one to sixty nine dollars a barrel. That's below the fiscal breakeven for Saudi Arabia, Iran, Iraq, Algeria, and most OPEC members. It's near the danger zone for US shale. Saudi Arabia is running a budget deficit north of five percent of GDP and borrowing to cover the gap while also increasing oil production as part of an OPEC+ agreement, a combination that pushes prices lower and makes the deficit worse. One more thing most people don't understand: how the barrel price connects to the pump price. When you pay four dollars a gallon for gasoline, about fifty to sixty percent of that cost is the price of crude oil. The rest is refining costs, distribution and marketing, and taxes. Federal and state taxes alone add roughly fifty to seventy cents per gallon in the US. So when oil drops from eighty dollars to sixty dollars a barrel, you might expect gas prices to fall proportionally. They don't. Refiners and retailers adjust slowly on the way down and quickly on the way up, a pattern economists call "rockets and feathers." Prices shoot up like rockets when oil rises and float down like feathers when oil falls. So if this comes up in conversation, here's how to think about it. Every oil-producing country has a number it needs oil to be at. Those numbers are all different, they're all in tension, and the price you see on the news is the result of that tension playing out through a cartel, a swing producer, and a futures market. Oil is priced in dollars, traded in futures, and fought over in a game where everyone's number is different. Stay informed, stay curious, and we'll see you tomorrow.