Round One: US Shale Wins, OPEC Loses
WASHINGTON – Here is the news. The US shale oil industry, while badly wounded by the price war waged by Saudi Arabia, is still standing and fighting on. In fact, it is now better than ever. Thanks to rapid technological innovation, it has been successfully re-engineered. Although bruised, it is slimmer, more productive and more efficient than ever.
Unsustainable low prices
Saudi Arabia instead may not be able to sustain its own scorched earth, low oil prices campaign; not because of its impact on Saudi oil profitability, (still very healthy); but because Saudi Arabia needs a much larger oil revenue to finance its budget and to continue subsidizing a population that looks at public money as an entitlement. Indeed, low oil prices for the indefinite future may jeopardize the very survival of the Saudi state.
How it started
A couple of years ago, when oil prices started sliding due to a supply glut, Saudi Arabia announced that, contrary to expectations, it would not cut production in order to jack up crude prices. This was an unusual reaction, and all analysts wondered what prompted it.
In the past, OPEC’s strategy had been to maintain price stability at a fairly highly level. Not too high so that it would financially damage buyers; but high enough in order to guarantee high margins for OPEC producers. That balance seemed to be with oil prices at around $ 100 per barrel. In order to achieve this goal, OPEC, led by Saudi Arabia, in order to support prices would cut production when supply exceeded global demand.
So, why the new course of action? Why would Saudi Arabia allow oil prices to slide? There were several theories. Saudi Arabia wanted to damage Iran. No, the Saudis were going after Russia, because they did not like its military support to Syria. But the most popular theory was that the Gulf oil giant wanted to kill its newest but possibly weakest competitor: the US shale oil industry.
Indeed, thanks to the use of hydraulic fracturing (or fracking) the booming US shale oil industry had surprised the entire world. Using fracking to extract oil from shale formations, with incredible speed American shale oil producers had added millions of barrels of US production in just a few years, this way creating the global oil glut that caused the rapid crude price decline. This sudden change in global demand and supply obviously worried the Saudis, the established oil markets arbiters.
That said, just like almost everybody else in the oil business, the Saudis “knew” that extracting oil from shale is very expensive. The consensus was that US shale oil could be profitable only with crude well above $ 60 per barrel.
Yes, shale oil production via fracking is a fantastic innovation. But production costs are much higher than the industry average. Therefore, if you wanted to get rid of this US shale oil annoyance that caused a global supply glut, just drive the price of crude way down for a while by over supplying already saturated markets, and the the US shale oil producers would go bankrupt. As easy as that.
Make them go bankrupt
And for a while it seemed that the Saudi game plan (assuming that this is what they were really trying to do) was actually working. With oil going from $ 100 to $ 60 and then down to $ 40 a barrel, US shale oil companies’ profits fell or disappeared altogether. The most indebted small and medium US producers could not get more financing. And so they went under. A large number of operations stopped.
It was a carnage. In just a couple of years, tens of thousands of shale oil industry jobs were lost. A very large number of vendors and suppliers to the shale oil sector suffered. Entire communities that catered to energy workers had to absorb major losses.
However, guess what, the huge body blow of declining oil prices that in no time had gone from $ 100 to $ 40 per barrel, or even lower, surprisingly did not kill the US shale oil industry.
To the amazement of all industry practitioners, the shale oil sector managed, in almost no time, to become more efficient and more productive. Costs were slashed, year after year. Oil recovery rates improved, quite substantially. Yes, as a consequence of falling prices, overall US oil production went from 9.7 million barrels a day down to 8.5 million; a net loss of 1.2 million. But the survivors are now nimble and profitable, even with oil below $ 50 per barrel. Many of them can still make money with oil at $ 40 per barrel.
Saudi Arabia now in trouble
Meanwhile, it looks as if Saudi Arabia cannot live much longer with the consequences of its own low crude prices policies. Let’s make it clear. The Saudi oil industry is not in any trouble. It remains very profitable even at low prices, simply because Saudi oil extraction costs are very low.
However, the problem is that the Saudi government needs oil at $ 100 in order to finance its budgets, public investments plans, and a variety of subsidies offered to almost all Saudi citizens.
Out of cash
Sustained low oil prices caused a sudden state revenue shortfall. And this has created a huge fiscal problem. For the time being, Saudi Arabia can cope. It has used some of its vast currency reserves. It has issued bonds to finance its large and expanding budget deficit. So far, so good. But the outlook is not at all promising. Assuming low prices for the indefinite future, little by little Saudi Arabia will run out of cash.
Given all of the above, at some point OPEC, led by Saudi Arabia, will have to cut production in order to increase oil prices. This will increase Saudi state revenues and stabilize the Kingdom’s fiscal situation.
Shale producers are more flexible
That said, this will also be good for US shale producers. Unlike other “conventional oil” producers, the US shale companies now have the technology that allows them to ramp up production relatively quickly, while cutting it when global supply is excessive. Which is to say that when prices go up more rigs will go into operation. When prices start sliding due to excessive supply, shale oil operators can shut down some operations, without going bankrupt in the process.
All in all, the plucky US shale upstarts, usually small companies sometimes poorly managed and not well-financed, managed to take huge blows, quickly reinvent themselves, and come back, stronger than before. This proves that disruptive technological innovation is possible –even in mature industries like oil. All in all, at the end of this oil price war round, shale wins, OPEC loses.