THE KINGDOM of Saudi Arabia is starting to feel what it's like to have the oil price rug pulled from under its feet. For the past several years, OPEC – aka Saudi Arabia – has pursued a policy of increased oil production in a low-demand, low-price environment in order to curtail burgeoning North American oil production and retain market share.
Here are the results of that policy:
- Canadian and American oil producers have cut production levels, and some mainly small- and mid-cap firms have declared bankruptcy. However, the decline in income forced the firms to find greater cost efficiencies, which has enabled them to produce crude more economically at lower prices. Many shale producers, especially those operating in the Permian Basin, say they can produce crude economically at $50/bbl and lower and plan to ramp up drilling and production levels in 2017.
- OPEC members such as Nigeria, Algeria, Libya, and Venezuela have been suffering through the low oil prices at least as much as North American producers. The US consumes a lot of the oil and natural gas produced here, so while petroleum producers suffered, US industrial, commercial, and individual consumers received enormous benefits from cheap oil and gas. The US economy has been outperforming that of just about every other nation on earth. Most of the OPEC nations are much more dependent on income from petroleum exports, which makes them more vulnerable to low oil prices.
- Saudi Arabia, with its enormous conventional oil reserves felt it could outlast the upstart shale players in the US and Canada. Initially, their plan worked, mainly because many of the shale producers had over-leveraged their companies in order to grow faster. However, the prolonged industry downturn has taken its toll on the Kingdom as well. The Saudi government's budget deficit has soared to about one-fifth of its total economic output year despite $57 billion in spending cuts for the current fiscal year. That amounts to roughly twice the size of the US budget deficit in 2009, the worst year of the so-called Great Recession, according to a recent Wood Mackenzie report. Low oil prices have forced Saudi Arabia to spend $180 billion in financial reserves, which has caused the Middle Eastern nation to rethink its OPEC production strategy. Wood Mac estimates that Saudi Arabia needs a $92/bbl oil price in order to balance its budget.
There are always at least two sides to every issue, and from the Saudi perspective, the government felt it needed to protect its share of the petroleum market by increasing production levels in a weak market. They believed this would cause some of the high-cost shale producers to go away. The Saudi energy minister, H. E. Khalid A. Al-Falih, persuaded his OPEC counterparts to go along even though it wasn't necessarily in their best interests to do so.
The subsequent pain the Saudi policy inflicted on its members is unprecedented, particularly in countries like Nigeria and Venezuela with developing economies and little cash reserves. Frankly, I'm surprised there hasn't been an uprising within the cartel by some of its poorest members. However, Saudi Arabia and its Gulf allies continue to hold all the cards. That is, perhaps, until now as the Kingdom begins to see the downside to long-term low oil prices.
From the shale producers' point of view, a rising tide lifts all boats. As Rick Muncrief, president and CEO of WPX Energy, told me recently in an interview for this month's cover story, he would like to see oil prices stabilized at $50 to $60 per barrel for the next 12 months. He thinks this level of pricing will improve the health of service companies and other industry vendors. "That's when you start seeing real growth again," Muncrief noted.
As we prepare to go to press with this issue of OGFJ, NYMEX oil futures are trading at about $45, and Brent is about $3 more. Prices in this range hold a high-risk potential for producers, according to several industry analysts.
OPEC is slated to meet in Vienna on Nov. 30 amid discussions about an OPEC deal to curtail production. So far, it appears that the two main adversaries within OPEC, Iran and Saudi Arabia, are hardening their positions. Iran steadfastly refuses to make production cuts, and the Saudis are insisting that Tehran must be willing to participate in any agreement.
Iran and Iraq have their reasons for not wanting to cut or cap production levels. The government in Baghdad wants an exemption from a supply deal and cites the urgency of its current offensive against ISIS. Iran seeks special treatment since it has finally started to ramp up production following years of crippling economic sanctions from the West.
While OPEC is trying to resolve its internal differences, the cartel has asked non-OPEC producers, including Russia, to reduce their output as well. To date, Russia, which has substantial economic challenges of its own, has stiffly resisted any effort to reduce its supply.
Any agreement or non-agreement reached during the OPEC talks will have a profound influence on producers and consumers of petroleum products. The difference this year is that Saudi Arabia now has the incentive to see that a deal gets done.