1. James A. Baker III Institute for Public Policy Energy Forum1 The Future of Saudi Price Discrimination: The Effect of Russian Production Increases Ronald Soligo Amy Myers Jaffe

2. James A. Baker III Institute for Public Policy Energy Forum2 Asian Price Premium

3. James A. Baker III Institute for Public Policy Energy Forum3 Explaining the Asian Price Premium The Asian price premium is the result of Saudi price discrimination Discrimination has been facilitated because of sanctions against Iran and Iraq (which have limited their production) as well as US policies prohibiting the export of Alaska crude. Price premiums will fluctuate because of the pricing formulae and other factors.

4. James A. Baker III Institute for Public Policy Energy Forum4 A Thought Experiment #1 Assume that there are only two - call them West and East. Both areas produce as well as consume oil in competitive markets. Assume that trade between them is not possible. Then, a price of oil will be established in each area- according to the demand and supply conditions prevailing in that area. The prices in the two areas will not necessarily bear any relationship to one another.

5. James A. Baker III Institute for Public Policy Energy Forum5 Thought Experiment #2 Now assume that trade between the two areas is possible but that there is NO cost of transporting oil from one area to the other. The oil will flow from the area where its price is lower to where it is higher. In equilibrium, the price will be the same in the two areas.

6. James A. Baker III Institute for Public Policy Energy Forum6 Thought Experiment #3 Now assume that trade between the two areas is possible but that there is a cost of transporting oil from one area to the other of $1.00. Now, oil will flow from one area to the other only if the price differential is greater than $1.00. If it is, oil will flow from the lower priced area to the higher priced area. the price of oil in one area cannot differ from that in the other by more than $1.00.

7. James A. Baker III Institute for Public Policy Energy Forum7 Price Discrimination And The Oil Price Anomaly The Asian price is higher than the European price. Yet oil flows from East from Middle East to Europe. How can this be explained? One answer is that Saudi Arabia has sufficient market power in the Asian market to permit it to price discriminate. Price discrimination is constrained by the cost differential of shipping West African crude to Asia versus Europe

8. James A. Baker III Institute for Public Policy Energy Forum8 Necessary Conditions to price Discriminate In order to profitably set different prices in two markets the elasticity of demand in the two markets must differ. Secondly, the price discriminator must prevent arbitrage by third parties. That is, prevent others from buying in the low price market and reselling in the higher priced market. Are these conditions satisfied for Saudi Arabia?

9. James A. Baker III Institute for Public Policy Energy Forum9 Exports of Middle East Producers

10. James A. Baker III Institute for Public Policy Energy Forum10 Exports of Middle East Producers Oman, Qatar and UAE export most of their oil to the Asian market. Kuwait exports over half of its production. The remainder is shipped to Europe, where Kuwait owns refineries, and to the US. Iraq ships westward through pipeline to Turkey. Shipping facilities in the South need repair. Iran ‘s exports to Asia are limited by US sanctions that prohibit US owned facilities to refine Iranian crude.

11. James A. Baker III Institute for Public Policy Energy Forum11 Controlling Asian Supply Saudi Arabia prevents resale of its exports with contracts baring resale without approval. Exporters must pay the formula price based on the destination of the crude. There are no other Middle East producers that could exploit higher Asian prices by significantly increasing their exports to Asia. The alternative to Saudi oil is West African crude - that suffers a transport cost disadvantage relative to middle East crude. Transport cost of West African crude to Far East is roughly 70-80 cents a barrel more than to Europe.

12. James A. Baker III Institute for Public Policy Energy Forum12 Determinants of the Demand Elasticity of Saudi Crude The elasticity of demand for Saudi oil in Europe is given by: where is the elasticity of demand for Saudi oil in Europe; is the elasticity of demand for oil in Europe, is equal to the quantity of oil consumed in Europe is the quantity of Saudi oil consumed in Europe is the elasticity of supply of oil, other than Saudi, to the European market

13. James A. Baker III Institute for Public Policy Energy Forum13 Profit Maximizing Conditions

14. James A. Baker III Institute for Public Policy Energy Forum14 Profit Maximizing Price Differential Recent Saudi shares of European and Asian markets are 8% and 15% respectively. Assume that the elasticity of demand for oil in both markets is 1.0 and that the elasticity of non-Saudi supply is.5 Then the Saudis maximize revenues by charging Asian buyers 4.9% more than European buyers - close to the 4.8% average price differential prevailing since 1990.

15. James A. Baker III Institute for Public Policy Energy Forum15 Alternative Scenarios Other scenarios suggest larger price differentials. For example the elasticity of non Saudi supply is much smaller in Asian market (as we have argued above) than in the European market where there are many alternative sources of crude. But Saudi Arabia price discrimination is constrained by the availability of competing crudes from West Africa. When Asian prices rise above European prices by more than 70-80 cents/barrel, West African crudes would increasingly flow to Asian markets.

16. James A. Baker III Institute for Public Policy Energy Forum16 Significance of Increases in Russian Exports-Long Run Scenario

17. James A. Baker III Institute for Public Policy Energy Forum17 Significance of Increases in Russian Exports-Long Run Scenario Russian oil will primarily be exported westward through Europe, the Baltic Sea and the Mediterranean. Asian import growth will increase Asian reliance on Middle East exports. Effect of growing Asia imports from Middle East on Saudi share depends on output increases in Iran and Iraq and not on Russian exports. The Saudi share in Asia is unlikely to diminish. It will decline in Europe - continuing (strengthening) conditions for price discrimination.

18. James A. Baker III Institute for Public Policy Energy Forum18 Significance of Increases in Russian Exports-Short Run Scenario Source: IEA; Deutsche Bank estimates

19. James A. Baker III Institute for Public Policy Energy Forum19 Significance of Short term Glut Aside from Iraq, extra output will come primarily from Africa, Russia, the Caspian etc. In other words from non Asian sources. If Saudi Arabia cuts output to support crude price in face of increased output from other sources, it would maximize revenues by cutting exports to Europe and the US - hence having little effect on its market share in Asia and the price premium. Significant increases in Iraqi export to Asia could reduce price premium in near term.