Policies of Scale: Efficient Global Policy

Battle Royale: Saudi v. American Oil

Saudi Arabia is trying to strangle American shale oil. They’ve been going at it for months now, and American shale has resisted. Forced into greater efficiency, production is up and American producers look better equipped to face low prices in the future. The Saudis are a bit surprised, but the battle is far from over.


Early last month I wrote that Saudi Arabia had realized that OPEC was no longer the market manager it once was, and feeling exposed the Kingdom had set out on a new strategy to mitigate the competition of shale oil so that it could build and run a new “global corporate oil board” that would effectively control prices like OPEC once did, even if it now required a different players:

“The Saudis have clearly been unable to give up their position as the CEO of the global oil market and are switching gears to re-arrange the corporate board. They have acknowledged that the shale producers have pushed aside previously important OPEC states, and that Iran stands to regain its influential position in the next five to ten years. Having faced this reality, the Kingdom is putting together its corporate strategy to bring [shale producing] countries into the market managing process knowing that they cannot or will not cut their production unless something dramatic happens in the market. So step one: force a cut in shale production to render irrelevant Western governments’ inability to regulate production.”

Headlines are ablaze this week with stories about American shale production recovery and a 40% rally in crude prices since March, resulting in $60 WTI barrel prices. Given the lean times, shale producers have been developing more efficient means of production and reevaluating supply processes. As a result, production is up, even though the operating rig count hit a six-year low this week and the Saudis themselves continue to pump away at their own record-setting pace.

So is the Kingdom succeeding in building its new global corporate oil board, or not? They have been trying to force a production cut, but examples of resilient American shale production abound:

-Statoil has trimmed four days off the average well-boring time, and has cut operating expenses by over 22% per well per annum

-New Bakken wells are adding an extra 200,000 barrels per day to the market each day, a one-third increase year-over year

-Eagle Ford’s new wells are adding 100,0000 barrels per day more

-WTI prices remain above the marginal cost of producing another barrel

-Well completion has been reduced from 35 days to 17 days

Major shale producers are promising bigger and better things if the price rises just a bit more. Tom Pugh, a commodities economist at Capital Economics, projected that “US supply could quickly rebound in response to the recent recovery in prices” and that “Based on the historical relationship with prices, the fall in the number of drilling rigs already looks overdone, and activity is likely to rebound over the next few months.” Goldman Sachs seems to agree, saying that if WTI prices settle above $60, producers will ramp up activity.

To this point, EOG Resources, which owns holdings across the country that comprise the largest combined production of any company in the country, have said that WTI prices above $65 per barrel would allow it to “resume strong double-digit oil growth in 2016.” However, efficiency gains require capital expenditure. Not every shale producer can afford them and for this reason EOG is not representative of American production. Comparatively, a $70 WTI barrel is the price “that turns it on for us,” “us” being Continental Resources Inc. and Whiting Petroleum Corp.

Even though they haven’t been able to force the big production cuts they’ve been seeking, the Saudis are not backing down from their strategy to out-produce their shale competitors. A Saudi official told the Financial Times this week that they believe their strategy of “squeezing high-cost rivals such as US shale producers is succeeding,” and the Kingdom’s April production demonstrated the positive outlook by setting a record high of 10.3 million barrels per day.

The International Energy Agency released its own data this week that backed up the Saudis’ optimism, saying that American shale production had “buckled” in April. Yet they also cautioned against “premature” conclusions that Saudi Arabia has won “the battle for market share” by noting that global oil supply was growing across the world, even in high-cost areas like Brazil, where production costs are even higher than in America.

Could it be, then, that the Kingdom’s goal is to demonstrate in the face of shale competition that shale is still responding to a market most influenced by Saudi Arabia? “Saudi Arabia wants to extend the age of oil,” a Saudi official told the Financial Times. “We want oil to continue to be used as a major source of energy and we want to be the major producer of that energy.”

Even though American shale production can compete on a quantity basis, that production represents many individual producers each operating with different financial considerations. Conversely, the Saudis operate according to one Oil Ministry and one ruling family. This central power combined with the largest oil reserves in the world has made Saudi Arabia the swing producer capable of single-handedly moving the oil market. It might not be able to cripple shale, but it can push out all but the most efficient producers.

The effectiveness of the strategy is influenced in part by the number of companies making independent decisions because the fewer decision-makers you have in American shale, the more American shale can act like a swing producer because producers can stagger outlays by drilling the well ahead of when they decide to pump it, a decision informed by market prices and extraction costs. This ability to drill and then wait to produce is one reason why American shale has been able to respond so quickly to the price rally of the last 3 months. Even though the collective lacks Saudi-style cohesion, the result can effectively be swing production. This relatively new phenomenon, however, needs to replicate itself again before it can be counted on to settle the market in the future.

In the meantime, consulting firm Petromatrix has coined the concept “shale band” which represents the range of WTI prices in which production remains relatively stable. The band is $45-$65 and in this range production remains stable relative to a price below the band at which production crashes and a price above the band at which production surges. The kicker is, the higher the proportion of the world’s oil supply that comes from shale, the stronger this effect will be.

An OPEC paper recently leaked to the Wall Street Journal has as its most optimistic scenario a barrel price of only $76. Consultancy IHS believes that 80% of new shale capacity this year will be profitable at WTI barrel prices between $50 and $69. Based on what we’ve already seen at prices between $40 and $60, American shale can be resilient to low prices when a competitor is trying to shut them down.

Saudi Arabia knows it needs American shale production on some level because, after all, Saudi cannot supply the whole market on its own and without other major producers the Kingdom loses the power of its outsized reserves. The global corporate oil board Saudi Arabia appears to be building is a work-in-progress and the power ratio between it and the other producers is settling, it hopes, towards an acceptable equilibrium. But this far into the process, the Kingdom has to be at least a little taken aback by the insistence of American shale oil producers that they deserve a high number of votes.

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