Saudi Arabia’s Destructive Oil Freeze
Riyadh has positioned global oil markets for a never-ending series of boom-and-bust cycles.
At OPEC’s December meeting in Vienna, the delegation from Saudi Arabia ignored the pleas of some of the bloc’s more economically fragile members, whose ranks include Nigeria and Venezuela, to cut output in order to halt the drop in crude oil prices. Instead, the Saudis insisted on maintaining production at its current levels. In the two months that followed, prices of Brent crude oil promptly fell from $40 per barrel to a low of $27 per barrel.
Since then, Saudi Arabia has agreed to “freeze” crude oil production at January levels, in an effort to stabilize global prices. But its strategy of helping drive that price down to $30 per barrel represents a serious miscalculation in its efforts to maintain control of the market. By taking advantage of an economic slowdown — primarily in China, where GDP growth has fallen by 30 percent — and pushing prices so low that very little new exploration makes commercial sense, Riyadh is planting the seeds of the next supply shortage.
That shortage is likely to produce a much steeper price recovery than would otherwise occur. This means that prices could rise to a level that would prompt substantial new investment in exploration — precisely what the Saudis are trying to avoid (or discourage). They would, in fact, be better served by less volatility and a price that is reasonable but not so high that it either encourages more expensive shale and deep-water oil projects or unduly enriches their enemies.
Instead, in response to $30 oil, public and private sector oil companies around the world are deferring or canceling billions of dollars in new projects and cutting billions in new exploration and development capital expenditures while laying off — and losing — technical capacity. The impact of those decisions on supply is only now becoming evident here in the United States, where the number of drilling rigs in operation has fallen from a high of 1,800 in 2014 to below 500 in 2016, according to oil services firm Baker Hughes. However, it will be abundantly clear to the rest of the world by 2017. The extreme economic distress now felt by both major- and minor-producing countries, and the inevitable tightening of budgets, will also contribute significantly to the shortage.
If you’re part of the Saudi government, perhaps you think that’s a good thing, since one of the objectives of supporting a price collapse is to reduce non-OPEC supply and inflict great damage on U.S.-based shale oil producers. Riyadh is succeeding on that front, as evinced by the fact that production from seven big U.S. shale plays is predicted to decrease by 106,000 barrels a day in April from March. It is also grabbing more market share by overproducing on its OPEC quota and discounting the price of its barrels, so as to undercut the Iranians, Russians, and others.
Some Saudis are likely to argue that, historically, when there has been excess supply, they served as the “swing producer,” cutting production to restore balance. When they played that role in recent years, like in 2009 during the global economic crisis, they lost market share to others. So why, Riyadh might ask, should it not take advantage of the fact that Saudi Arabia is one of the lowest-cost producers, in order to increase its market share in a low-price environment? It’s an understandable, if extremely short-sighted, position.
The cumulative impact of both the public and private sector capital expenditure reductions across the globe could result in as much as a 5 percent reduction in supply, which, at current production levels, amounts to nearly 5 million barrels a day. Even if the reduction winds up being less than 5 percent, with very modest growth in global demand, a sizable gap between supply and demand will emerge — one that cannot be easily filled.
The Saudis would be happy to fill that gap, but they don’t appear to have much additional capacity readily available. The Saudis have, roughly, 1.5 to 2 million barrels a day of additional production capacity. But 500,000 barrels are sour — meaning that they contain too much sulfur, or heavy crude, which can only be refined in a few places like the United States. The other million barrels require new drilling and infrastructure. The Iranians, Libyans, Iraqis, and Russians all have some additional capacity, but it takes time and capital to reach that potential, and capital is in short supply. At the right price, U.S. shale producers who survive this collapse will be back out in force. However, it will also take time for them to arrest the erosion of supply and begin restoring production. (You can’t simply turn on a spigot. That’s because oil is a declining and depleting resource. Instead, you rebuild it through new drilling.) As a consequence, there’s nowhere to turn quickly to fill the gap. When that becomes apparent, prices will rise sharply.
A smarter strategy for the Saudis would have been to manage a price in the range of $40 to $60 per barrel, a level at which many shale areas are not very profitable, particularly if the costs of rigs, oil-field services, and pipes — which have declined by some 30 percent over the past year — start to rebound. Indeed, some of the more capital-intensive, large reserves, such as the “pre-salt formation” off the coast of Brazil, or the oil sands in Canada, struggle for real profitability at $40 to $60 per barrel.
Over the past 18 months, as the price of crude has fallen from $100 per barrel to under $30 per barrel, analysts and commentators have grown fond of predicting that, unlike the last few oil price declines that were followed by sharp recoveries, this time is different. This time, they say, the price will stay “lower for longer.” If the Saudis had not pursued their current strategy of flooding the market and driving prices down so far, that probably would have been the case. But the damage has largely been done, unless the price quickly jumps back up to about $70 per barrel and the surplus barrels currently hanging over the market disappear quickly. Given the shortage the Saudis are helping create, we may be bound for yet another boom-bust-boom cycle.
Such cycles are unhealthy. They cause massive swings in the cost of energy and other commodities, as well as in public and private sector budgeting, investing, and employment. And since the last swing, the oil and gas industry has undergone revolutionary change, thanks to the advent of shale production. In a global market that is less susceptible to manipulation, the price of crude should be determined by the marginal cost of producing new shale barrels. However, the Saudis are not ready to accept that idea, because with it comes the realization that the influence and control that OPEC has wielded over crude markets for the past 40 years is shifting from the Persian Gulf to North and South America. Riyadh may be able to delay that day, but it can’t avoid it. In the meantime, it has done serious damage to the global economy, and to itself.
Photo credit: Bloomberg