By Leonid Bershidsky | Bloomberg View
The big oil-producing countries keep on pumping, even though prices are at a six-year low: Don’t they know they’re only making things worse? Chances are they do—each has its own reasons to continue—but this won’t go on forever. Someone will blink in the next year or so, most probably US shale producers.
In the US, the crude oil price has dipped below $40 a barrel. Brent, the European blend, trades below $45. Still, output from the Organization of Petroleum Exporting Countries (Opec) increased to 31.5 million barrels a day in July.
Production in Saudi Arabia, Iraq and Venezuela is at or near the highest level in a year. Russia, now the biggest crude producer in the world, increased its output by 1.3 percent year-on-year in January through July, and is pumping 10.6 million barrels a day. US production has dipped slightly in recent weeks, to 9.3 million barrels a day from the June peak of 9.6 billion, but it’s still substantially higher than a year ago, when prices were more than twice as high.
The simplest explanation for this phenomenon is that the producers need the cash; the lower the price, the more they need to sell to maintain revenue. Among the trio of top oil producers—Russia, Saudi Arabia and the US—this need-for-cash argument works best for Russia. Last year, as crude prices began to tank, it quickly floated its currency. Since then, the ruble has devalued in lockstep with oil, so that every extra barrel sold produces the same revenue in rubles, which is the currency of the government’s budget. As a result, Russia has no reason to cut production, even if it probably will suffer a future decline in output, because its major oil companies have sharply reduced investment.
The Saudis haven’t unpegged the riyal from the US dollar, so selling more oil at lower prices doesn’t make much economic sense for them. They are convinced, however, that it makes strategic sense. Although the first onslaught on the US shale producers has proved ineffective, they are determined to press on. “It is becoming apparent that non-Opec producers are not as responsive to low oil prices as had been thought, at least in the short-run,” the Saudi central bank said in its latest stability report, adding:
The main impact of the current lower prices has been to cut back on developmental drilling of new oil wells, rather than slowing the flow of oil from existing wells. Thus, the impact of lower prices today is expected to be on future oil production, rather than current production. This requires more patience on Opec oil producers and a willingness to maintain steady production until the demand catches up with the current supply levels.
The risk for the Saudis is that they have misjudged US shale. Last year investment banks estimated break-even costs for major US shale plays at more than $60 a barrel, but a recent Bloomberg Industries analysis suggests this was inaccurate. It shows, for example, that in North Dakota’s McKenzie County, part of the Bakken shale play, the break-even price is about $29. Neighboring counties only need a slightly higher price to break even. Analysts had underestimated the ability of tight oil producers to cut costs and apply new technologies to increase output per rig. The US Energy Information Administration says production per rig has significantly increased in the past year, for all of the country’s shale areas.
That, however, was only to be expected in a price war. The Saudis couldn’t have hoped that their US rivals would just roll over and won’t be deterred by this show of resilience. Besides, they have reason to believe that new technology and cost-cutting weren’t the only reasons US shale hasn’t buckled.
In July Bloomberg News reported that at least 15 percent of the first-quarter revenue for 30 of 62 oil and gas companies in the Bloomberg Intelligence North America Exploration and Production Index came from hedges, derivative contracts that allow producers to lock in prices. In effect, the hedges allow companies to go on receiving a higher-than- market price for their output. The share of revenue accounted for by hedges is likely to have increased in the following two quarters, as crude became cheaper.
The hedges are a big part of the explanation why US companies have maintained production levels, but most will run out by the end of this year. It’s unlikely they will be renewed, because it’s too expensive in the current market to fix future prices at up to $90 a barrel, the kind of money frackers are often still paid now, thanks to derivatives.
At that point, US drillers will find it difficult to pay back their combined $235 billion of debt. By then, the added technological and financial efficiency unleashed this year will have peaked. New credit will be less readily available and the shale drillers won’t be able to repeat their feat from the first half of 2015, when they raised $44 billion through bonds and share sales. Even if their break-even costs are lower than previous estimates, the low crude prices make them look unattractive to lenders and investors.
To predict who is going to gain ground in this drawn-out price war, it’s worth assessing the protagonists’ arsenals. Apart from $672 billion of international reserves (a cushion that shrank 8.5 percent between January and June), the Saudis still have the devaluation card up their sleeve. When Kazakhstan belatedly followed Russia in abandoning its dollar peg last week, Prime Minister Karim Massimov predicted that Saudi Arabia and some of its Gulf neighbors would also have to float their currencies to deal with the new reality of crude prices. And the Saudi financial system has other untapped resources: the country doesn’t currently even collect income tax; it pays out huge energy subsidies that could be cut; and its government debt is just 1.6 percent of gross domestic product, leaving lots of room to borrow.
King Salman may not want to throw those reserves into a price war with US shale, of course, but he has them. By contrast, all that protects American frackers is their ability to innovate and drive costs down. This year has shown that ability is not to be underestimated, but it is surely finite—at any rate, US production has stopped growing.
In those circumstances, it’s understandable that the Saudis are unwilling to accept defeat. Saudi Arabia won’t be satisfied with another temporary rebound in oil prices, such as the one that occurred last spring: Their US competitors would just increase output again. They must inflict permanent damage by demonstrating to investors that with shale, they can’t bet on any kind of predictable return. So far, the (probably overblown) threat of Iran’s return to global oil markets is helping the Saudis with this task, but it’s a long-term gamble and the situation is volatile.
The Saudis may be temporarily thwarted by production decreases in those oil economies unable to hold their corners in the price war, such as Nigeria, where production has been in decline since last fall. Lost production in these countries may send prices up again slightly, giving US frackers a little more breathing space. But until either the US shale industry or Saudi Arabia has triumphed, the onlookers—even big ones like Russia—won’t be able to benefit from higher oil revenue.