Saudi Arabian Price War

Jim Brown
 
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I wrote a lot about the OPEC decision in the Option Investor commentary this weekend. Since I posted that newsletter we have learned that the majority of OPEC members supported a 1.5 mbpd cut as well as a 500,000 bpd cut from non-OPEC members. That was voted down by Saudi Arabia. As the largest producer they pretty much get their way.

If OPEC had cut by 1.5 mbpd the majority of those cuts would have fallen on the GCC countries of Saudi Arabia, Kuwait, Oman, Qatar and the UAE. The rest of the crowd would have supported the decision but not acted on it. They would have continued to produce at maximum levels. Saudi Arabia said no deal and no cuts.

Since Saudi Arabia has a cost of production somewhere less than $20 they have a lot of economic firepower. If they ramp up their excess capacity they can increase production from their 9.0 mbpd to 11.0 mbpd within months. They can offset the lower price per barrel by producing the extra 2.0 mbpd. Nobody else in OPEC has that capability.

Basically Saudi Arabia declared a price war on the rest of OPEC, Russia and U.S. shale production. Back in 1998 Saudi did the same thing. The other OPEC members were not obeying their quotas and Russia was ramping up production to 10 mbpd and stealing market share. In order to force OPEC compliance with the pricing targets Saudi opened all the pipelines and flooded the market with crude oil. The price per barrel declined to $10.65 and the lowest level since the $9.65 in 1986. When you get into a fight with somebody you don't want it to be the biggest bully on the block. Saudi Arabia crushed the rest of OPEC and caused the oil industry in the U.S. to crash. Active oil rigs fell from a high of 4,530 in 1981 to 488 in 1999. Entire generations of oil workers quit the oil patch and found jobs elsewhere. Oil production plummeted from 6.4 mbpd in February 1998 to 5.6 mbpd in Sept 1999 headed for a low of 3.9 mbpd in 2005. Saudi won the war, OPEC members fell back into line and prices rebounded and were stable and rising for the next decade until the financial crisis ended the constantly rising demand and allowed production to catch up and eventually exceed that demand.

While I hope Saudi Arabia is not attempting to repeat the 1988 price war it is always possible. They have more to lose this time because it is not just OPEC members they are fighting. Iran could quickly add 1.0 mbpd if sanctions were lifted. Iraq is up to 3.3 mbpd and headed for 5.0 mbpd in a couple years. Brazil was an oil importer back in 1998 with 1.2 mbpd of production and today they are producing just over 2.1 mbpd with 4.0 mbpd targeted by 2020. The U.S. has boosted production from 3.93 mbpd in September 2008 to 9.08 mbpd last week. All of that increase replaced oil imported from the Middle East. This is what Saudi Arabia is fighting. Their market share is declining and they are no longer receiving tens of billions of U.S. dollars for their oil sales. Now they are selling in other currencies and having to convert those currencies into dollars at a sizeable loss. They need U.S. dollars to support their overseas trade where goods and services are traded in dollars.


If Saudi Arabia can knock the U.S. shale industry back to square one U.S. production will drop like a rock. Shale wells deplete by about 65% in the first year and 35% in the second year. If the pace of new wells slows dramatically then depletion will catch up and production will fall sharply. The only reason we are staying ahead of the depletion curve today is because we are drilling more than 9,100 wells per quarter.

We ended 2013 with production of 8.121 mbpd and that has risen to 9.08 mbpd last week. The EIA expects it to rise to only 9.4 mbpd in 2015, 10.0 mbpd in 2016 and then decline beginning in 2017 as the shale drilling race runs its course and companies run out of places to drill. If Saudi Arabia's price war knocks active rigs back from the current 1,929 to 1,600-1,700 then production will peak in the next couple months and begin to decline. Unless we can keep the active rigs over 1,900 we can't keep up with depletion.

Another factor in the Saudi decision is the damage they can do to the shale industry. Quite a few shale drillers are racing the checks to the bank. They borrow huge amounts of money to fund drilling and then race to drill those wells and produce cash flow before the payments come due. Analysts believe the oil industry is 15%-20% of the entire high yield debt market. When oil prices crash, positive cash flow stops and suddenly companies are struggling to pay the bills. Rigs get cancelled, employees laid off, and earnings turn into losses.

A reader pointed out to me this weekend that not only will banks and lenders be on the hook for delinquent loans if oil prices stay low but service companies like Halliburton, Schlumberger, U.S. Silica, Baker Hughes, etc, will be on the hook for work performed but not paid.

If prices only stay low for several weeks and begin a slow rebound into the normal winter rally then maybe these events don't happen. However, if Saudi Arabia is really determined to put a lot of shale companies out of business as a long term deterrent to future production then they have the capability to push prices a lot lower and keep them there for a long time.

Saudi Arabia has the capability to bankrupt nearly every small to medium E&P company on the planet. They just have to decide if the short term pain is worth the long term gain.

If Saudi Arabia is serious about this price war then $50 is an easy target and $40 is not impossible. However, they don't have to push prices that low. If they hold them in the $60 level that will be enough to shut down nearly all of the shale drilling in the U.S. within a year. The breakeven on most of them are in the $60-$70 range or higher but they don't get WTI prices. Shale producers typically sell their oil for $7 to $10 less than WTI because of transportation costs and the ultra light quality of the oil. Refiners are geared up to process heavy crude because they can extract more products from a barrel of heavy crude than from a barrel of ultra light shale crude.

With WTI at $65 some shale producers will actually be getting $55 and they can't drill these expensive wells for $55 a barrel. Drilling will come to a halt very quickly once the cash flow stops.

You may have noticed the natural gas prices fell with oil prices despite the monster -162 Bcf withdrawal from storage last week. This is a sympathy drop. Everything energy was sold. However, if the number of active oil rigs declines then gas production will also decline and gas prices should rise. We are also entering the winter cycle where numerous gas wells quit producing when the weather falls below freezing. The water particles in the gas freezes and production is "frozen out" of these wells until warm weather returns. Back in 2011 the cold weather knocked more than 7 Bcf per day off of production because of freeze outs. We don't have the numbers for 2013 but I am sure they were significant. With single digit temperatures all over the country the last several weeks gas demand is soaring but gas production is probably declining. We started the winter demand cycle with gas storage levels about 350 Bcf below year ago levels and we almost ran out of gas last year. Time will tell if this is the winter where rationing begins.

Oil Inventories

Crude inventories rose +1.9 million barrels to 383.0 million. We are probably about a week away from the seasonal peak. Inventories normally decline into yearend because refiners are taxed on the amount of oil in inventory on December 31st. U.S. production rose to a post 1986 high of 9.08 mbpd.

Refinery utilization rose to 91.5% and the highest rate since summer. Input of oil to refineries rose to 15.96 mbpd and a multi-month high. Product output rose to 20.48 mbpd and also a multi-month high. Imports declined slightly to 7.47 mbpd and -6.5% below year ago levels.

Gasoline inventories rose +1.8 million barrels to 206.4 million. Gasoline demand rose to 9.25 mbpd and a multi-month high. Lower gasoline prices are a huge stimulus and promote more driving. As prices decline further we can expect demand to continue increasing.

Distillate inventories declined for the fifth week with a -1.6 million barrel decline to 113.1 million barrels and a multi-month low. Jet fuel and heating oil saw increased demand for obvious reasons.

Cushing inventories rose to 24.6 million barrels and a multi-month high.

In the graphic below green represents a recent high and yellow a recent low.


Propane inventories fell -1.95 million barrels to 79.2 million. Demand rose from 1.34 mbpd to 1.55 mbpd. With cold weather continuing across the Midwest and Northeast I would expect to see increased demand for the next couple of weeks.

Natural gas inventories declined -162 Bcf to 3,432 bcf. Inventories are now -10.4% below the five year average at 3,832 Bcf and -9.2% below year ago levels at 3,778 Bcf.

Market

The market ended the week at new highs on the major indexes. Thanksgiving week retained its historically bullish trend. The fundamentals are strengthening but the market remains very overbought. Profit taking could occur at any time. Crude prices and S&P futures are down late Sunday night and Monday could see some margin call selling in energy equities.

Jim Brown

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