Opportunity Cost of Oil for Public Decision Making in Saudi Arabia Peter Hartleyᵃ, Chris Jones, Fatih Karanfilᵇ, Kenneth Medlockᵃ, Axel Pierruᵇ, Ted Temzelidesᵃ ᵃ Baker Institute for Public Policy, Rice University  ᵇ KAPSARC  Email: fatih.karanfil@kapsarc.org

Defining shadow price/opportunity cost Shadow price is the implicit value (or cost) associated with a constraint. It is the value achieved by relaxing the constraint by one unit. Opportunity cost is the “value that is given up or sacrificed in order to secure the higher value that selection of the chosen object embodies” (Buchanan, 1991, p. 520). Production factor A B C D Return of the production i = 𝑅 𝑖 𝑅 𝐴 > 𝑅 𝐵 > 𝑅 𝐶 > 𝑅 𝐷

Defining shadow price/opportunity cost (cont.) For an exhaustible resource, shadow price reflects opportunity cost. If we use a barrel of oil today, we cannot use it tomorrow. Similarly, if it is used in a particular way, it cannot be used in another. Distortions: Taxes/subsidies or production/export controls also impact shadow price. The objective of shadow pricing is to estimate the price of a given commodity that reflects more accurately the “real” value of that commodity, given the distortion. Shadow prices are not equilibrium prices that would prevail in a distortion free economy. Understanding the shadow price of oil is important because it influences the optimality, and hence desirability, of undertaking policies that effect consumption or production. Shadow prices depend on the fundamental objectives of the country.

Research questions and objectives For a major oil-exporting country, what is the shadow price of oil? Develop a framework that can be applied to the case of Saudi Arabia but can also be generalized. How do various non-commercial factors or social concerns impact the shadow value of oil (different objectives to maximize)?

A very sparse literature Correlation: 0.83 Scopus share: Share of (“opportunity cost” or “shadow price”) and (“oil” or “energy”) in publications in Scopus within the subject areas of Economics and Energy. Nominal oil price: Two-year lagged value of crude oil price (in dollars). Source: Authors’ calculations based on Scopus and BP.

Divided thoughts Distribution of responses to the question “What is the opportunity cost of oil for Saudi Arabia?” by participants (local stakeholders and international experts) to the workshop on the opportunity cost of oil, July 24, 2018, Riyadh.

Approaches: 1. Estimation of trade opportunity costs Little and Mirrlees (WB, 1974) suggest for an exported good: if the demand is perfectly elastic, it should be valued at its f.o.b. price. in the case of inelastic world demand, it should be valued at marginal revenue. Opportunity cost of a tradable resource is given by the contribution that it may make to the balance of payments.

Approaches: 2. A national oil producer concept Consider a project that would free a barrel of oil from domestic consumption. The project must be valued based on the opportunity cost of the barrel that is saved. Domestic oil price is fixed by the government and corresponding domestic demand must be met. Since the saved barrel cannot be sold on the domestic market (which would require lowering the price), it must be either exported or left underground.

Case 1. Producer has excess production capacity Non-zero spare capacity implies that available capacity does not constrain export decision. If it were optimal to produce and export an additional barrel, the producer would do it in the baseline. Value of a barrel saved equals value of a barrel in underground reserve plus extraction cost Capacity Spare capacity Production Exports Domestic demand

Case 2. Production capacity is binding A barrel of oil freed from domestic consumption is exported immediately. Opportunity cost is the incremental revenue from exporting an additional barrel. If producer already exports a large quantity of oil, this additional barrel can lead to a measurable reduction in revenues from existing exports (which depends on price responsiveness of the demand for the producer’s oil). Opportunity cost is market price less reduction in revenues from existing exports. Production = Capacity Exports Domestic demand

Approaches: 3. A 2-period model - Price maker, but depletion raises the marginal cost of extraction. Domestic price of oil is an administered price. - Price taker, price of oil is set equal to the backstop price. Oil rents disappear, the government introduces income taxes. Employment quotas in different sectors of the economy

Approaches: 4. An optimal subsidy problem An optimal subsidy system in a model where the revenues are expected to continue into the future as well. Oil subsidy causing large distortions to economic activity with significant welfare losses Government may consider other ways of returning its oil revenues to the private economy Measure the marginal excess burden (MEB) of the consumption subsidy on oil and how much each dollar spent on providing the good raises private surplus.

Conclusion and research perspective No study to date has specifically investigated this issue Many constraints and factors that influence the opportunity cost of oil Price responsiveness of international demand for Saudi oil Consider two contrasted cases: marginal producers in Texas versus a large state low-cost company in Saudi Arabia