The Saudis Hold the Line
Sunday, November 30, 2014 at 1:04PM The big news in the oil world last week was a do-nothing policy by OPEC, and especially by the Saudis, the swing producer of oil. By swing producer I mean that Saudi Arabia has the physical, political and financial capacity to adjust its oil output to suit its policy goals. OPEC met this last week and decided to leave its output at 30 million barrels a day, despite the abrupt drop in world oil prices. Crude oil closed Friday at $66, down from $110 not long ago.
You’d think that the Saudis would want to cut production to tighten supply and bring the price back up. By some accounts, they can’t meet their national fiscal goals unless the price of oil is above $90 a barrel. They aren’t losing money, even at $66, as their cost of production is the lowest in the world at $3-6 a barrel. However, oil being essentially their only source of income, their national budget is in deficit at present prices.
My guess, along with some other observers, is that they are playing the long game.
The rising production of shale oil in the U.S. is a big part of the problem for the Saudis. Although temporary, our production increase has pushed down our demand for oil on the international market. It’s an expensive process, though. A shale exploration company has to drill multiple boreholes that turn horizontally and follow the thin layer of oil containing shale. Then they have to force fluid and sand into the holes in order to fracture the shale and let the oil out. This is hydrofracturing, popularly known as fracking. The nature of these wells is that they produce large amounts of oil initially and then rapidly decline, sometimes within months. Then the driller has to pack up the equipment and repeat the process elsewhere.
There are a number of oil producing shale formations in the U.S., but only a small percentage of the total shale area is highly productive. Some of the shale exploration and production industry was losing money even at higher prices. The business plan for a number of companies seemed to consist of outlasting competitors and reaping the benefits of future high prices.
The expensive production cycle and money-burning nature of the industry requires a constant influx of money, both as investment and credit. That is what the Saudis are after.
By maintaining the world supply of oil at present levels OPEC can keep the price of oil below the breakeven price for many shale oil companies. Beyond that, a lower oil price means that drillers lose access to credit. Just as the resale value of your house backs your low-interest mortgage, the estimated value of a drilling company’s oil reserves serves as security for loans. When the price of oil drops they have to resort to higher interest unsecured loans and divert present income to exploration, all of which discourages both banks and investors.
OPEC doesn’t have to drive all of them out of business. They can pick off the stragglers, the companies most overextended and possessing the least productive oil field leases. A string of bankruptcies in the shale oil industry would not only lower production, but also choke off investment and credit. That would hamper present production and slow the return of the shale oil industry when prices recover. The threat of repeated Saudi intervention would keep banks and investors at a distance.
The Saudis are willing to spend some sovereign wealth to clear the field of competition. With currency reserves over $700 billion, they can endure $66 oil for a while longer. Much longer, I’ll bet, than the U.S. shale industry.
OPEC, Saudi Arabia, fracking, oil in Economics
Reader Comments (2)
In addition to the global-scale predatory pricing that MH describes, the OPEC nations may want to be certain that Americans (especially) indulge their taste for gas guzzlers. The sales figures announced periodically by the carmakers make clear that we rush back to buying heavy SUV's, Bubba pickups and the like the moment the pump price retreats.
The U.S. vehicle fleet got old during the recession. It's replacement time. If we renew our fleet with fuel hogs, a hefty gas-sales volume will be baked in for another 6, 8 or 10 years down the road. So it pays to take a loss now and then, lest the addict have time to get clean of his habit.
Very good point, Doug. Any slowdown in the march towards efficiency has a long hangover. Not just with vehicles, either. Lower prices for fuel oil and propane will slow down home and business energy efficiency measures.