SAUDI ARABIA V SHALE – A Game Of Chicken!

In the world of oil many conspiracy theories prevail. Most of them are complex, opaque, and most of all, highly political. But one of them is about plain vanilla competition. Although never mentioned explicitly, the decision by OPEC not to lower production was surely aimed at driving, at least some, U.S. shale producers out of business. As a result the oil market has turned into a game of chicken. But who’s winning?

Oil Production is UP!

In November of last year, OPEC, quite unexpectedly, decided not to lower production quota, even though at that time the price of crude oil had already plummeted 30%. After OPEC’s decision, oil crashed another 40%, causing severe headaches for everyone that makes a living from producing oil. And that is exactly what OPEC, and more specific, Saudi Arabia, wanted to happen. At that time at least. This is underpinned by the graph below, which shows that, since August of last year, oil production by OPEC actually increased. Moreover, in its latest monthly market report OPEC states that last month the organization pumped the most crude oil in more than three years. Saudi Arabia, OPEC’s leading producer, has also significantly raised production, revealing that OPEC is not at all aiming for higher oil prices.

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Amazon-like Strategy

Quite the contrary! OPEC has adopted an ‘Amazon-like’ strategy in which it (together with Non OPEC producers) floods the market with crude oil, driving down the price of oil along the way, in an attempt to wipe out the competition. OPEC has shown clear willingness to absorb losses, perhaps for as long as necessary, to drive its competitors out of business. And by competitors, I mean U.S. shale oil companies, obviously!

As the graph above already revealed, U.S. production of crude oil grew at an even faster pace than OPEC’s. Since August last year U.S. oil production is up by more than 13%. Most of that increase is related to shale oil producers. And it’s not just the last 12 months. Since the beginning of 2010, U.S. crude oil production increased by a staggering 84%. That massive increase enabled the U.S. to reclaim its spot as the biggest oil producer last year, according to BP’s Statistical Review of World Energy.

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The U.S. already became the world’s biggest oil supplier back in 2013, stealing market share from OPEC and other producers. And, because of the massive increase in U.S. production, oil inventories have also gone through the roof. Crude oil stocks in Cushing, Oklahoma are up 219%(!) since August last year.

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Demand is falling

At this point, it’s pretty clear that the Amazon-like strategy followed by OPEC is amplified by the fact that demand fell more than expected. This has a lot to do with the disappointing growth numbers we are getting out of emerging markets. GDP growth in emerging markets rebounded to above 9% right after the financial crises, but has, since then, more than halved. Especially the declining growth rate in China has caused global demand to fall back quite aggressively. As a result, the mismatch between oil supply and demand is strikingly large. No wonder oil prices have collapsed.

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Don’t expect the imbalance between supply and demand to go away anytime soon, either. This week the International Energy Agency (IEA) reported that the oil glut will persist well into 2016 and that global inventories will pile up further.

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Break-even

The combination of rising supply and lower demand, as described above, has resulted in the game of chicken we are now witnessing. Now that oil prices are low, lower than expected, the question is, who can endure those depressed prices the longest? Who is last to blink? Saudi Arabia or shale?

Perhaps just one or two years ago the obvious answer would have been Saudi Arabia. Because the country knows the drill, has the power of being the swing producer (although this is now debated) and because U.S. shale gas producers needed very high oil prices to get to break even. But as it turns out, it could well be the other way around. It’s the U.S. shale industry that’s winning this game.

So, why is that? Below is a familiar table citing the oil price levels at which oil-producing countries are able to balance their budget. Many of these countries require an oil price of at least USD 100 to reach fiscal break-even. In case of Saudi Arabia oil needs to get back up to USD 103 to reach break-even (other estimates put this number even higher). Also note that the required break-even oil price is rising as the country struggles with rising unemployment (youth unemployment currently measures 29%) and a massive increase in defence spending. The IMF estimates that Saudi Arabia could report a budget deficit of 20%(!) of GDP this year. You can’t have too many of those, or you will end up like Greece.

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And U.S. shale companies? Below is another familiar graph, showing the break-even oil prices for US shale oil projects as estimated by Wood Mackenzie. Forget the names of these projects (if you can read them at all), what’s important is that the graph shows that the average oil price needed to get to break-even is USD ’70-ish.’ It could be a few bucks more or less than 70, but in any case significantly lower than the USD 103 that Saudi Arabia needs to balance its budget.

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But there’s more. It’s reasonably likely that this table, which was published on the Business Insider website back in October 2014, is already seriously outdated. Energy analytics company IHS thinks that shale companies could cut production costs by 45% this year alone. And, by the end of next year costs could be down by as much as 70%. 70%! If we translate this to break-evens, oil prices in the range of USD 40-50 would make a great number of the shale projects, shown in the Wood Mackenzie table, that were assumed unprofitable, profitable again. Hence, where the break-even price is going up for Saudi Arabia’s budget, they are rapidly coming down for US shale companies.

The fast decline in break-even oil prices is also an important explanation for why production of U.S. shale companies has kept on growing despite the massive decline in oil rigs. They enable shale companies to ramp up production from wells that remain profitable. If anything, the production of the U.S. shale industry has proven to be far more resilient than estimated.

Defaults

However, the sheer magnitude of the oil price collapse (60% from the peak in June 2014) doesn’t leave the U.S. shale industry unharmed. Looking at U.S. high yield statistics reveals that energy companies account for half of all defaults this year (source JPMorgan high yield data.) This number will surely rise in the near future as a number of shale companies are already trading at distressed levels. A big issue for these companies is that banks are reassessing future cash flows based on lower oil prices. As a result a number of these companies will be unable to refinance, which in most cases leads to default. However, the market seems to be overestimating this trend. The current spread on high yield energy companies implies a cumulative default rate of 15%. I have seen no high yield analyst, so far, that expects the default rate to hit this level. Again, the sizeable cost reductions, shale companies are realizing, are not adequately taken into account.

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Round up

Of course, the massive drop in oil prices is going to impact supply at some point. Many high-cost projects like those in the Gulf of Mexico, Canadian tar sands and the Russian arctic have already been shelved. Wood Mackenzie estimates a total of USD 200 billion of investment has been deferred. Oil capex is falling the most since 1986 this year.

But if OPEC and Saudi Arabia wanted aimed to wipe out U.S. shale oil companies by not lowering production back in November, they have not succeeded. If anything this ‘game’ has made the U.S. shale sector leaner, faster. Shale companies are simply no longer ‘high-cost.’ Lower break-even prices gives the U.S. shale industry the edge in the game of chicken it’s playing with Saudi Arabia. Also, expect any significant spike in oil prices to be matched by an immediate rise in shale oil production. This will leave little room for structural higher oil prices. At the same time, OPEC’s role in the oil market looks smaller than ever and Saudi Arabia is left with a budget deficit of 20% of GDP.

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