When the Saudis announced their intention not to support oil prices when they were sliding towards $90 and plunged quickly through that level, we deemed the move to be a masterstroke. It served to damage both economic and political enemies. On the economic front, the casualties would include renewables, Canadian tar sands, and the US shale gas industry. On the geopolitical front, the casualties would include Iran, Syria, Russia.... and the US.
Even though Riyadh is nominally still an ally, relations with the US are fraught. The Saudis are mighty unhappy with America over its failure to get rid of Assad, its refusal to indulge Saudi demands of attacking Iran (our leaders may be drunk on power, but they haven't quite gone over the deep end) and or indirectly working with Iran against ISIS (which started out as Prince Bandar's private army and may still have the kingdom as a stealth patron). So the Saudis are not at all unhappy if the US suffers as a result of the whackage of its energy industry. First, that's an inevitable outcome if the Saudis are to succeed in maximizing the value of their oil assets, which is a survival issue for the royal family. Second, since relations between the US and Riyadh are frayed right now, it is an opportune time to show that the kingdom is not to be treated casually.
Yesterday, the Saudis made it even more clear that they are not pulling out of their game of chicken with other energy producing nations. The Saudis will keep pumping and by implication, will force production cuts on others. But in its clever formulation, which has the advantage of being true but misleading, the Saudis insist that all they are doing is preserving market share. Key sections of the Financial Times report:
Opec will not cut production even if the price of oil falls to $20 a barrel, the cartel's de facto leader said, spelling out a dramatic policy shift that will have far-reaching implications for the global energy industry.
In an unusually frank interview, Ali al-Naimi, the Saudi oil minister, tore up Opec's traditional strategy of keeping prices high by limiting oil output and replaced it with a new policy of defending the cartel's market share at all costs.
"It is not in the interest of Opec producers to cut their production, whatever the price is," he told the Middle East Economic Survey. "Whether it goes down to $20, $40, $50, $60, it is irrelevant."
He said the world may never see $100 a barrel oil again....
In the MEES interview, Mr Naimi said Saudi Arabia and other Gulf oil producers would be able to withstand a long period of low crude prices, largely because their production costs were so low — at only about $4-$5 a barrel.
But he said the pain will be much greater for other oil regions, such as offshore Brazil, west Africa and the Arctic, whose costs are much higher.
"So sooner or later, however much they hold out, in the end, their financial affairs will limit their production," he said.
"We want to tell the world that high efficiency producing countries are the ones that deserve market share," said Mr Naimi added. "If the price falls, it falls . . . Others will be harmed greatly before we feel any pain."
We had argued that many US shale producers might still keep pumping at a loss, since they needed to keep generating cash flow to service debt. And if they still have open credit lines, they could also borrow to keep producing in the hope that they would ride out what would prove to be a short-lived downdraft. Many Wall Street analysts are predicting that oil prices will rebound in the second half of 2015 as energy producers cut back on output. But if too many suppliers all make the same bet, that they cna stay the course because someone else will make cuts, then output levels won't drop as much as analysts anticipate and pries will stay low longer.
The stern words from the Saudis are clearly meant to speed up that process. We'll see how quickly US producers act as if they have gotten the memo. A separate Financial Times story shows how a major Bakken player is slashing capital expenditures (which has ramifications for his suppliers and his employment level) but plans to produce more from fewer wells:
Continental Resources, one of the largest oil producers in the Bakken field in North Dakota which has been at the centre of the US shale resurgence, has cut its 2015 capital spending plans for the second time and intends to reduce the number of rigs it has operating by nearly 40 per cent....
Continental said late on Monday that it planned to spend $2.7bn on wells and other investment next year — down significantly from its previous plan of $4.6bn, which in turn was a reduction from its original target of $5.2bn.
It added that it expected to cut the number of drilling rigs it was using from about 50 today to an average of 31 for next year.
The company also said it expected to be able to cut the cost of its wells by about 15 to 20 per cent.
In spite of the planned fall in its capital spending, however, Continental still expects its average production next year to be 16-20 per cent higher than its average for 2014.
Notice that Continental plans to stay at cash flow breakeven:
Mr Hamm told the Financial Times the cut was intended to bring Continental's capital spending "pretty close" to its cash flow from operations, so that it would not have to increase its borrowings.
But since shale wells show sharp production declines after the first two years, Hamm's "do more with less" strategy looks to be a clever short-term expedient. He can't afford to cut development for too long, or else his production in a year or a bit more will start to taper off.
And notice how his price forecast is consistent with current US conventional wisdom and at odds with what the Saudis have in mind:
Mr Hamm, who started out in the oil business driving a truck in 1963, said he had seen "about half a dozen" such cycles in his career. He added that he expected prices to settle again at about $85-$90 per barrel, and "eventually" return to the $100 per barrel level seen in June.
It seems reasonable to expect oil prices to their old levels in light of peak oil, but that belief may also reflect anchoring. Before the Saudi bombshell, Anatole Kalecki argued oil could fall to $20 a barrel if the OPEC regime didn't hold. The Saudi "pump, baby, pump" strategy is tantamount to OPEC abandoning its cartel role. From Anatole Kaletsky in Reuters:
Low oil prices will last long enough for one of two events to happen. The first possibility, the one most traders and analysts seem to expect, is that Saudi Arabia will re-establish OPEC's monopoly power once it achieves the true geopolitical or economic objectives that spurred it to trigger the slump. The second possibility, one I wrote about two weeks ago, is that the global oil market will move toward normal competitive conditions in which prices are set by the marginal production costs, rather than Saudi or OPEC monopoly power. This may seem like a far-fetched scenario, but it is more or less how the oil market worked for two decades from 1986 to 2004.
Whichever outcome finally puts a floor under prices, we can be confident that the process will take a long time to unfold...
There are several reasons to expect a new trading range as low as $20 to $50, as in the period from 1986 to 2004. Technological and environmental pressures are reducing long-term oil demand and threatening to turn much of the high-cost oil outside the Middle East into a "stranded asset" similar to the earth's vast unwanted coal reserves. Additional pressures for low oil prices in the long term include the possible lifting of sanctions on Iran and Russia and the ending of civil wars in Iraq and Libya, which between them would release additional oil reserves bigger than Saudi Arabia's on to the world markets.
The U.S. shale revolution is perhaps the strongest argument for a return to competitive pricing instead of the OPEC-dominated monopoly regimes of 1974-85 and 2005-14. Although shale oil is relatively costly, production can be turned on and off much more easily – and cheaply – than from conventional oilfields. This means that shale prospectors should now be the "swing producers" in global oil markets instead of the Saudis. In a truly competitive market, the Saudis and other low-cost producers would always be pumping at maximum output, while shale shuts off when demand is weak and ramps up when demand is strong. This competitive logic suggests that marginal costs of U.S. shale oil, generally estimated at $40 to $50, should in the future be a ceiling for global oil prices, not a floor.
The Saudi determination to hold its position and force adjustment onto higher-cost producers makes this Kaletsky scenario seem more likely than it did when he wrote it. And that means optimistic US producers will have to wait much longer for their $100 a barrel payday than they expected and have to do a lot more creative production juggling in the meantime. As as shale producers have to contend with maturing debt, some may not be able to manage all the moving parts. As the Saudis hold to their guns, we can expect to see debt restructurings and asset sales. It won't happen overnight but the combination of high debt levels, lack of access to cheap junk bonds, and a big fall in revenues means the air supply of these producers has been cut in a big way. Some will still prosper in these new conditions, but right now, we are seeing a lot of denial as to how much downshifting and reorganizing is likely to take place over the next eighteen months.