What really happens if Saudi Arabia starts pumping more oil?

A month ago, I wrote about “why OPEC will never cut production again.” This weekend we saw Saudi Arabia put an exclamation point on the matter by scuttling a deal in Doha for an oil production freeze. The repurcussions of this decision will obviously be far reaching.

Stating that “if we don’t freeze, then we will sell at any opportunity we get,” Saudi Prince Mohammed bin Salman made it clear going into the meeting that Saudia Arabia would not let up on production unless Iran agreed to a freeze, too. Given that Iran said they would not even attend the meeting, the outcome was not surprising at all, except to most oil analysts (see my ranking compared to theirs on TipRanks).

The Saudi Prince went on to say that Saudi Arabia could pump 11.5 million barrels per day (bpd) anytime, up from the current 10.4 million bpd. He also said it would only take about six months to ramp up to 12.5 million bpd if they were so inclined. We should expect to see those increases in production and capacity sometime soon. With more Red Sea development looming, it would not be surprising to see Saudi Arabia ramp up capacity even more if demand supports it.

The Prince’s words are not idle thoughts. There is a purpose behind every syllable. The higher-cost oil producers, and their financiers, must completely understand that Saudi Arabia sees driving them out as in the Kingdom’s best long-term interest.

While a lot of breath and keystrokes have been expended on speculating about the geopolitical drama between Saudi Arabia and Iran in this oil price war, the likelihood is that is a minor consideration for Saudi Arabia. The impact on Russia is not likely a significant consideration either.

To be sure, the U.S. has no problem with what is going on as cheap oil is good for the domestic economy, excluding oil, of course, and it puts economic pressure on suspect regimes. Ultimately, the Saudi actions are based on self interest though.

A new approach

This weekend, Saudi Arabia announced their transition plan away from oil. They will be creating a sovereign wealth fund and floating 5% of Aramco, the state-owned oil company. This is a clear signal that Saudi Arabia’s actions will revolve around the idea of maximizing profits while they can.

The first part of the Saudi strategy is to gut the high-cost producers and their financial backers. The second part will be to soak up as much market share as possible, without triggering prices to sustain high enough to encourage high-cost competitors to re-enter the market.

Last September, when I wrote that we were seeing “the end of deep-sea oil drilling as we know it,” even I thought that Saudi Arabia would begin to tighten production coming into the summer 2017 driving season in America. The Prince’s words though make it clear something else is going to happen. Saudi Arabia doesn’t want their oil to become landlocked as the “oil age slowly ends.”

The repurcussions

The impact of Saudi Arabia’s strategic approach is for another crushing blow to ultra-deep-water drilling, which requires huge up-front costs and long payback periods to be economic. Deep-water service companies are very vulnerable to deep water producers changing their investment strategy for future production. Already we have seen Conoco Phillips COP, +1.97% Devon Energy DVN, +0.96%  and Apache APC, +1.88%  walk away from deep-water development. New U.S. regulations to prevent and clean up the spillage in deep-water drilling also adds to the pressure on companies in the deep water drilling services space.

For investors, because the deep water mega-projects of the past will be fewer and further in between as oil demand flattens, and ultimately falls when electric vehicles take hold in the 2020s, staying away from the value trap that most deep-water drillers are, is important. Even with modest short-term demand growth, Saudi Arabia and American frackers will mostly fill that supply need. The simply truth is that there simply isn’t enough demand left or likely to develop in the industry to support all of the players, even though they have all shrunk already.

Among the large offshore drillers, Seadrill SDRL, -1.96%  appears to me to be the most likely to not come out of this downturn healthy. Seadrill’s debt is still high, there are few buyers for their equipment, and there is little work likely to develop in coming quarters or years. I would be a seller of Seadrill on the recent rally, not a buyer.

MarketWatch