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Saudi Arabia can't save us from high oil prices

March 21, 2012: 11:45 AM ET

Saudi Arabia promises to fill in the supply gap if the Iranian crisis escalates, but there's only one place that can help stave off high oil prices: Wall Street.

By Cyrus Sanati, contributor

Riyadh, Saudi Arabia

FORTUNE -- Saudi Arabia can't save the West from rising oil and gasoline prices -- only Wall Street can.

The Kingdom announced earlier this week that it was increasing crude production in a bid to shake off supply concerns involving a potential shut off of Iranian oil supplies. While Saudi Arabia does have a massive reserve base, it can't fight this latest run-up in prices on its own. It is already running close to its production limit and it's unclear it can bring enough supply online to fill an Iranian void. Furthermore, even if Saudi Arabia could somehow fill a hypothetical supply gap, it is unlikely it would really make much of a difference in a market where speculators on Wall Street continue to hold large bullish positions in crude and gasoline futures.

The average price for a gallon of regular gasoline in the U.S. is averaging around $3.86 a gallon, which is a record high for this time of year and 9% above where it was during the same time last year. Much of the increase can be traced back to crude prices, which have moved up considerably amid supply concerns stemming from tensions over Iran's nuclear program. Tighter sanctions by the U.S. and Europe have hit a nerve in Tehran, provoking a war of words that have made investors nervous.

Despite the verbal assaults, there has been little impact on global oil supply as a result of the tougher sanctions on Iran. OPEC estimates Iran produced 3.424 million barrels of oil a day in February, which is off around 5.4% from the 2011 average. Increased crude production from the rest of OPEC, namely Libya and Saudi Arabia, more than made up for this small decline in output. Meanwhile, the U.S. market continues to be well supplied. There is currently enough oil in commercial oil storage tanks to cover 57.5 days of demand, which is 4 days more than a year ago and 6.6 days more than the five-year average.

But it is the potential for a massive supply disruption that is adding a special premium to oil prices, even though such a possibility is remote. Saudi Arabia's oil minister told reporters last week that the Kingdom stands ready to "make good any shortfalls – perceived or real – in crude oil supply." This week, the Kingdom's cabinet released an official statement saying that it "alone" would supply enough oil to the markets to return prices back to what it deems to be a "fair" level for consumers. U.S. benchmark crude futures shed about $2 after the news, to end Tuesday at $106.07.

MORE: Forget drilling, oil needs a crackdown on market gaming

But while the news is comforting, it really has little substance. Saudi Arabia is already breaking its own OPEC-imposed production quota limit (as are most other OPEC members) and producing an astounding 9.9 million barrels a day, putting it close to a 31-year production high. The Kingdom's production engine is firing on all cylinders with the number of drilling rigs in operation, up significantly from the same time last year. It is even going to start drilling in retired oil patches to squeeze out any extra oil that might still be underground.

Officially, Saudi Arabia's full production capacity is around 12.5 million barrels a day, which is 2.5 million barrels a day above its current production level. It also just happens to be Iran's production limit, which could lead one to believe that the Saudis could possibly make up for any lost Iranian production. But given the frenzied production rates of late and all the new drilling rigs in operation, many analysts believe that it would take several months to push production up to its ceiling. And even if it could somehow hit that level it may not be sustainable as it would mean raising production to levels that could actually damage the fields.

Furthermore, any major conflict that would see Iranian production reduced to zero would have major spill-over effects. In the unlikely event that Iran did close the Straits of Hormuz, one of the market's "perceived threats," that would not only cut off the bulk of Iran's own oil exports, but it would also cut off the bulk of Saudi Arabia's exports. Around 20% of the world's traded oil, some 17 million barrels, passes through the Straits every day. Most of that oil comes from Saudi Arabia. The only alternative is to ship the oil across the country via the 745 mile East-West pipeline that dumps out into the Red Sea. The pipeline has a nameplate capacity of just 5 million barrels a day, half of the Kingdom's current production. In addition, oil exports from Iraq, Kuwait, and the UAE would be severely disrupted in such a scenario.

The chance Iran would close the Straits is very small as it would be the equivalent of committing economic suicide. But Wall Street seems to think that this scenario or something equivalent is plausible enough to go long the crude markets. This has created an upward spiral in prices.

MORE: Why gas prices won't influence the election

Now, blaming speculators for high prices is nothing new. What is new is that one of the largest speculators in the oil markets, none other than Goldman Sachs (GS), admitting that heavy speculation does have an impact on oil prices. How much? Well, Goldman's oil analyst wrote in a note last month that every million barrel equivalent of oil futures that was net long the market adds 10 cents to the price of oil. The market is currently net long US benchmark crude, or WTI, by 258,406 contracts which is equivalent to 258 million barrels of oil. At 10 cents per every million barrels, that would mean speculation is currently adding $25.80 to every barrel of oil -- without the excess speculation, oil would trade at around $81.52.

This premium in the oil price is part market-specific and part fear premium. Passive investment funds that have a long bias, ETFs and commodity bulls keep the crude contract in the net long category usually all the time. The fear premium added by the Iranian situation has just exacerbated this distortion in the price. This fear premium will continue for as long as Wall Street is worried. So even if Saudi Arabia could flood the market with oil and plug any perceived supply shortage, it wouldn't make a difference unless this overhang in speculation is addressed.

The next time the President heads to the Middle East to discuss high oil and gasoline prices, he would be wise to make a pit stop on Wall Street.

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