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Page added on October 15, 2014
Saudi Arabia Still Calling the Shots
The US Shale Oil Boom
There have been a lot of stories over the past few years about the implications of the US shale boom. To review for those who might have been living in a cave for the past 5 years, the marriage of horizontal drilling and hydraulic fracturing (fracking) has reversed 40 years of declining US oil production and created a shale oil and gas boom.
As amazing as it would have seemed a decade ago, US oil production is increasing at the fastest pace in US history. In the past 5 years US oil production has increased by 3.22 million barrels per day (bpd). The overall global oil production increase during that time was only 3.85 million bpd, meaning the US was responsible for 83.6 percent of the total global increase over the past 5 years.
This resurgence in US oil production has had a number of implications. One has been that US oil imports have declined. Thus, even though the US has an oil export ban in place (which has had the impact of discounting US crude relative to globally traded crudes), global oil supplies have nevertheless increased as oil exporters sought other outlets to replace the declining US business. This has weakened the pricing power of OPEC.
Shale Oil Economics
The shale boom was enabled by high oil prices. The cost of production for shale oil is higher than for most onshore conventional oil, and therefore high prices were needed to encourage shale oil production. How high? Estimates vary, but a couple of years ago the marginal cost for shale oil was estimated to be around $100/bbl. That cost has been declining as drillers implemented improvements like multi-pad drilling, and today is probably ~$80/bbl. With the price of West Texas Intermediate hovering around $80/bbl, the market price of crude oil in the productive shale regions has slipped below $80/bbl (due to the need to transport it to market, it generally trades at a discount to WTI).
What does this mean? If the price of oil falls below the break even level for an extended period of time, marginal producers will begin shutting down and lower cost producers will likely reduce their spending on new exploration and drilling. The current expansion of US oil production would then stall sooner than expected.
Who would benefit if this happened? In the long run, Saudi Arabia, other OPEC producers, and Russia. The world’s other major oil producers have watched US oil production grow, and it looks like they might finally be ready to do something about it.
Saudi’s Three Options
When you think about it from Saudi Arabia’s perspective, they have three choices. They can choose to do nothing, in which case oil prices might weaken as long as long as US production continues to grow. At the rate the US is going, we threaten to overtake Saudi Arabia as the world’s largest oil producer within the next few years ago. A few years ago I would have been incredulous at this notion, but at this point I can’t say that’s impossible.
Saudi can also convince OPEC producers to cut production in order to support current oil prices. This will force them to give up some revenue, but again, if US oil production continues to increase OPEC may be forced to keep cutting oil production for the next few years in order to maintain global oil prices. As with the previous option, this benefits US oil producers.
Their third option does not benefit US oil producers. Saudi could attempt to reduce the price of oil until shale oil production starts to become uneconomic. Saudi Arabia has been accused of using oil in the past as an economic weapon. In the present case, it would mean short term pain for OPEC, but if they can stop the momentum of the shale oil boom then OPEC would regain some of its pricing power. Saudi Arabia reportedly needs oil prices between $80 and $90/bbl to balance its budget, and if they can short-circuit the US shale boom they will have more influence in ensuring they can set the price where they want.
This third option looks increasingly like Saudi Arabia’s strategy. Reuters reported this week that Saudi Arabia has been quietly telling the oil market that it would accept oil prices as low as $80 for up to two years. If this is the case, and Saudi Arabia manages to hold oil prices at $80, the result may be lower US oil production in future years than would have otherwise been the case. Saudi Arabia would once more be entrenched as the most powerful country when it comes to setting the price of oil.
Conclusions
As I have argued in the past, I view it as a serious national security concern when a country could bring the US economy to its knees overnight. Saudi Arabia still wields significant pricing power, but that power has weakened in recent years. If they win a price war with US shale oil producers, consumers will benefit at the pump while the war wages, but at a cost of putting more long-term pricing power in the hands of Saudi Arabia.
Whether we do it with increased oil production, lower oil consumption through higher fuel efficiency and alternative energy – or some combination, we need to make sure our energy policies do not put the future of the US economy back in the hands of countries that do not have the best interests of the US at heart. For some additional perspective on this issue, see my colleague Jennifer Warren’s article The OPEC Oil Market Gambit.
Consumer Energy Report » R-Squared Energy Blog by Robert Rapier
20 Comments on "Saudi Arabia Still Calling the Shots"
Makati1 on Wed, 15th Oct 2014 9:08 am
The USSA economy has not been in the hands of the US for a long time. We spend more than we make. We have been living on borrowed money, at least since the 70s.
The Saudis don’t control it either. They are limited by their own greed and the need to pay off their citizens. They can only play the low price game for a few months. But, that might be good enough to take down the fraking industry and maybe cripple the tar sands. That would be a good thing.
It will not affect Russia as China has their financial back and is also the Saudi’s biggest customer now. As the EU and Obama are finding out, that boomerang can come right back and kick your butt. All current events are doing is pushing the eastern and southern countries tighter together and away from the USD. The sanctions are hurting the EU more than Russia. But then, the Euro was getting too strong and threatening that Charmin dollar. Maybe that was the real goal of the sanctions?
We live in interesting times.
shortonoil on Wed, 15th Oct 2014 9:23 am
Robert Rapier is an excellent analyst in the petroleum field, but he has fallen prey to the same ideology that most have. He has failed to recognize that price is not a cause; it is an effect. The Saudi’s are no more in control of oil prices than the man in the moon. Depletion is now driving prices, and will continue to into the future. Shale production will decline because it is a high production cost, low energy source of a liquid hydrocarbon. The Saudis are not needed to bring about its demise, and have no capacity to do so. They no longer have the capability to increase production. The best they can do is maintain the production level they already have, and that will be only for a short period.
Petroleum’s capacity to drive the world’s economy is declining. Each year the energy needed to produce petroleum, and its products goes up; each year the energy that a unit of it delivers to the rest of the economy goes down. The economy slows and demand is reduced, and the price falls. Our model indicated that this would start to occur around 2016 at $117 per barrel, with a 4.5% error margin. It is possible that things have begun sooner than we anticipated.
What we are witnessing is likely the last phase to the oil age. Production cost rise, and price declines. Producers, one after another, are squeezed out of the market, and the world economy continues to contract. Recognizing what is actually happening is essential to preparing for a world that will not be powered by petroleum. The transition that is coming is inevitable; denying it will not make it any easier!
http://www.thehillsgroup.org/
Plantagenet on Wed, 15th Oct 2014 9:28 am
If KSA is going to flood the market with cheap oil, then the world economy should party like its 1999.
ghung on Wed, 15th Oct 2014 9:47 am
Plant, it doesn’t matter how big and wild the party is if you still can’t afford the cover charge. I think a lot of folks have found a different party, knowing the price of admission to the last party just got too high.
RSVP: “Sorry. We’re making other arrangements.”
bobinget on Wed, 15th Oct 2014 9:59 am
Permission to change the title of this article to:
“Saudi Arabia Still Calling the Shorts”.
Still waiting in Ashland for Shale Oil Peak..
JuanP on Wed, 15th Oct 2014 10:06 am
An RT article on the oil glut. Oil prices at a five year low now at $84.04 at time of publication.
JuanP on Wed, 15th Oct 2014 10:07 am
rt.com/business/196092-oil-glut-5-year-low/
Perk Earl on Wed, 15th Oct 2014 10:30 am
The answer as to what has been driving sharply lower oil prices finally dawned on me this morning and it is one word:
“DEFLATION”
Think about this; the US has had 3 QE programs since 08, which is when the price of oil then went from a post oil price collapse in the high 30’s to above 100 a barrel. It went into the high 120 and has stayed above 100 for all this time except when the QE program is tapering to zero, ending later this month.
Think of it this way; the sick patient was on a drip for six years of a total of 4.5 trillion money added to the monetary system from 2008 to late 2014, which works out to be 750 billion a year.
Then the patient has his drip bag tapered to zero and a world oil price bout of DEFLATION occurs.
But MSM not understanding what is actually occurring anoints the historical swing producer; Saudia Arabia as the power behind the drop below 100 dollars.
I posit that deflationary market forces were present that entire time of 2006 to 2014, but were not realized until the drip bag (QE) was taken away.
Perk Earl on Wed, 15th Oct 2014 10:37 am
The last paragraph should have read, 2008 to 2014, not 2006 to 2014.
rockman on Wed, 15th Oct 2014 10:50 am
As shorty points out it really isn’t that complicated. The KSA doesn’t directly control what oil sells for. The refiners decide how much they will pay…that sets the price. And if the refiners anticipate lower demand/prices they won’t pay more for the oil then would allow an acceptable margin. Same old story: supply and demand. What the KSA does control is how much oil they export. They could cut exports and thus cause oil prices to increase. But would it increase their export revenue to sell less oil at a higher price? Difficult to judge with the dynamics shifting so quickly. Like every seller they’ll look for that “sweet spot” of max revenue.
But as the global economies appear to be slowing it will be a tough call IMHO. Likewise if lower oil prices eventually provide economic improvement care would be taken to not stymie that expansion. It can take a year or more to make such judgments accurately.
Will the KSA be upset if lower oil prices reduce the development of oil resources in other countries? Obviously not. But OTOH the KSA also had 100’s of $billions budgeted for their future oil development projects so the joy is not without some cost. But OTOOH delaying those projects all more funds to be available to keep their citizens content.
Nony on Wed, 15th Oct 2014 11:07 am
KSA will try to get the rest of OPEC to go along with the production cuts. This is a more complicated dance than just single swing producer. With U.S. shale adding 1 million bpd/year when oil was above 100, KSA can not (for long) set the price themselves. They need/want others to participate also. Would not be surprised if there were some back channel coordination with Russia also.
Northwest Resident on Wed, 15th Oct 2014 11:10 am
“If KSA is going to flood the market with cheap oil…”
Since when is $85 per barrel “cheap”?
Maybe it is “cheap” in relation to the $100 price that held for so long. But “cheap” in relation to the historical price of oil it ain’t. In relation to the historical price of oil, $80 – $85 is still astronomically high, and still a far greater price than the world economy can efficiently run on.
Northwest Resident on Wed, 15th Oct 2014 11:41 am
Add to my above post: As shortonoil points out, with each passing year the energy that a unit of oil delivers to the rest of the economy goes down.
Asking consumers to pay more and more for less and less works only so long. There does come a point where the consumer just throws up his hands and says “screw it, I can’t afford that crap”.
It seems we have arrived at that cross section of the two divergent trends, or we are very, very close.
Kenz300 on Wed, 15th Oct 2014 11:53 am
Deep water drilling, shale oil and tar sands are all very expensive oil to develop.
KSA is trying to bankrupt its competition which is over extended and hoping for higher oil prices to make them profitable.
Cheap oil for a year or two will bankrupt many competitors and scare away others that were thinking of investing.
In the long run the price of oil is going higher…… in the short run KSA has the leverage to bankrupt some of its competition.
Northwest Resident on Wed, 15th Oct 2014 12:13 pm
Saudi Arabia’s most high-profile billionaire and foreign investor, Prince Alwaleed bin Talal, has launched an extraordinary attack on the country’s oil minister for allowing prices to fall. In a letter in Arabic addressed to ministers and posted on his website, Prince Alwaleed described the idea of the kingdom tolerating lower prices below $100 per barrel as potentially “catastrophic” for the economy of the desert kingdom. The letter, first reported online by the FT, is a significant attack on Saudi’s highly respected 79-year-old oil minister Ali bin Ibrahim Al-Naimi who has the most powerful voice within the Organisation of Petroleum Exporting Countries (Opec). Prince Alwaleed – who is a member of the ruling house of Saud – is also a major international investor, who holds significant stakes in companies from News Corp through to Citigroup.
ht tp://www.telegraph.co.uk/finance/commodities/11162744/Saudi-Prince-Alwaleed-says-falling-oil-prices-catastrophic.html
J-Gav on Wed, 15th Oct 2014 12:22 pm
You’re right guys. The Saudis don’t “call the shots.” My guess is that they’re testing the waters for political reasons, perhaps in conjunction with some deal made with other participants in a ‘secret’ plan. Nevertheless, they do still wield considerable clout and not only within OPEC.
Perk Earl on Wed, 15th Oct 2014 12:28 pm
“As shortonoil points out, with each passing year the energy that a unit of oil delivers to the rest of the economy goes down.”
I agree with that due to declining EROEI, but why did it manifest itself with oil prices dropping so far so fast? Without QE juicing the system deflation rears it’s ugly head and has a secondary effect of leading to recession. The timing I suggest is not coincidental.
What happened to supply increases just recently to perpetrate that big of a drop in oil price? Why didn’t normal market supply & demand factors alter oil price over a longer period of time?
Let’s look at the factors contributing to deflation/recession, either of which can contribute to an oil price drop (as we witnessed in 08 with recession breaking out and price dropping to high 30’s):
– Value of dollar rises against other currencies due to QE tapering to zero.
– Investors adjusting oil portfolios ahead of Fed start to selling bonds purchased during QE which will raise interest rates and have a recessionary effect.
– Stock investors now following oil traders with Dow losing 1000 pts. over last 6 trading days, due to same fears and lack of QE money funneling into the markets.
– EU in full fledged recession with even Germany slightly in the red now.
The only thing that has appreciably changed in the last couple months is QE tapering to zero, finally having it’s deflationary effect after 6 straight years averaging 750 billion a year.
If I’m wrong, someone’s got to talk me down. If I’m right, the price of oil will continue to drop to about 65-70 for Brent and the Dow will dump down to about 11-13k.
This new oil price will reflect our world economy post stimulus. From here or soon we descend from peak oil as marginal sources mothball.
Perk Earl on Wed, 15th Oct 2014 12:42 pm
Here’s a news flash: https://www.google.com/?gws_rd=ssl#q=dow+jones
Dow down at the moment 420 points! to
15,894. down from 17,000 just 6 days ago! Oh my.
Davy on Wed, 15th Oct 2014 12:53 pm
Perk, after the election there is talk of another QE if inflation falls below target. Personally I feel diminishing returns has hit QE so it is not going to be enough to lift markets. It may stabilize them but once you have a sell off like what may be coming damage is done to the broader economy. People feel poorER and bad bets have to be covered. People fail to appreciate how bad margin calls can be on risky investments. There are so many vulnerable investments that are waiting to evaporate like a popcorn fart. I feel this will be the recession that has been wallpapered over but will show itself like water stains one can never completely hide. This is the inflection we have been discussing here for so long. I hope I am wrong and Marm and NOo can accuse me of peddling doom.
Perk Earl on Wed, 15th Oct 2014 12:59 pm
I agree with all of that, Davy, particularly that QE was having diminishing returns. Once off the juice as you say the damage will be done. I don’t see how we do not soon descend from peak oil as marginal plays shut, and how long things can hold together is anybody’s guess. But I am doomerish too because once the descent from peak ensues, it just doesn’t seem like it will be long before shtf.