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| Saudi Arabia Oil Minister |
U.S. Oil Production
Energy prices could go up
at the same time that energy production could continue to decrease, although
not as much as simple supply/demand forecasts would expect (see prior post). Crude oil prices would have to rise from
current $35/barrel level to at least $50/barrel to stabilize production and
over $60/barrel to start increasing production.
Similar percent increases would be needed for natural gas.
For most shale oil and
natural gas producers, virtually all operating revenue is now going to debt
payments. After hedges come off, the
number of bankruptcies and “distressed debt” will accelerate in second quarter
of 2016. The companies can continue
production but bondholders, lenders and stockholders will suffer even larger
losses. This trend has already started
in the junk bond market and the fall of public oil companies’ stock prices.
Why Saudi Arabia Misjudged U.S. Oil Production
While OPEC countries produce 40% of the world’s oil, there
is no consensus on policy. Just the
opposite. There are deep rifts between
countries, as discussed in earlier posts.
Saudi Arabia and its allies believed that all-out production
would quickly create a global glut, falling prices and a sharp cutback in U.S.
and Canadian production. Unlike most
countries, American oil is produced by private companies that have to worry
about profits and meeting debt obligations.
But over the last year, U.S. oil production has stayed high and is only
now beginning to decline. This has
occurred even though the number of drilling rigs has decreased. What the Saudis misjudged was that American
drillers adapted to lower prices by shutting down low-producing wells, using new
technology to increase output per well, reducing drilling costs by drilling
deeper faster, and forcing suppliers to reduce their prices to producers. Breakeven prices came down. However, at $35/barrel, virtually all drillers
are losing money. More and more are
having trouble meeting debt payments from operating income. In the last two weeks, three junk bond funds
have folded, mostly because of losses on energy junk bonds. Total oil production is starting to decrease.
One reason that American oil production stayed at higher
levels than the Saudis expected is that when oil prices began to go down in
late 2014, many drillers hedged part their production. This means that they locked in prices higher
than the declining market (spot) prices.
Revenue was higher than forecasted just from looking at market prices.
If I Were the Oil Minister of Saudi Arabia
There is still too much global oil production as inventories
continue to build up. There is an
estimated 30 billion barrels of oil in inventory, about 33 days of
consumption. The only growth sector of
the oil industry is the building of storage facilities. Some oil is being stored on tankers at sea.
Price increases will lag any production declines as
inventory is worked down. Global
production will probably have to decrease by at least 2 million barrels per day
for some time before supply comes back into balance with demand and prices rise,
even if global demand is stagnant.
As Saudi oil minister, I would continue all-out
production. Most of the American hedges
expire in the fourth quarter of 2015 and the first quarter of 2016. By the end of the second quarter of 2016, the
financial condition of American drillers should be critical. More drillers will declare bankruptcy. But again, the decrease in production will be
less than forecasted. By declaring Chapter
11 bankruptcy, drilling companies can continue in operation without the major cost
of debt expense. Companies will merge
and assets will be sold. Even given
this, the Saudis can probably expect total U.S. and Canadian production will
decline by about one million barrels a day.
Besides Saudi Arabia and its allies, a number of other
countries both within OPEC and outside OPEC would also like to decrease
production. Prices would rise but only
if other countries did not raise production to take away market share.
With inelastic demand, the percent reduction in total output
would be less than the percent increase in price. Total export revenue would increase.
If I Were Vladimir Putin
While a number of countries might be willing to make a small
percent reduction in production, the two wildcards are Russia and Iran. Russia and Iran, as supporters of the
government of Syria, are geopolitical rivals of Saudi Arabia. But another year of low oil prices would put
serious strains on the domestic economy and the government finances of
Russia. President Putin might calculate
that the political risks of continued low oil (and related natural gas) prices
are too high.
Russia, one of the three largest oil producers, might keep
production high for domestic political reasons and “free-ride” on a global
price increase. Iran, recently released
from economic sanctions, has announced planned increases in production. Russia might work out a long-term deal with
Iran that would have economic and geopolitical benefits. Russia would slightly cut back production
(about 2 1/2% to start) and buy Iran’s increased output as a substitute and
resell it to Europe. Over time, Russia’s
older fields would have declining production and Russia would abandon plans for
very expensive (and unprofitable) Arctic exploration projects, which relies on
Western technology. Instead, Russia
would buy increasing amounts of Iranian oil.
In exchange, Russia would build more nuclear power plants in Iran and
supply Iran with uranium (and arms). Russia
and Iran have already agreed to the first steps of a nuclear power plant deal;
it could be expanded as Iran sells more oil to Russia. Both Russia and Iran would benefit from higher
global oil prices without an explicit deal with Saudi Arabia.
Conclusion
Global oil production has to fall by about 2 million
barrels/day from its current level of around 92 million barrels/day to work
down inventories and increase prices. By
the middle of next year, half of the decrease will come from the U.S. and
Canada. So the rest of the world only
has to decrease production by 1%-2% for prices to eventually rise. A price increase to the $50-$60 range –
40-70% from the current benchmark prices – would greatly increase the hard
currency export earnings of all oil exporters and probably not lead to
production increases in the U.S. and Canada.
This seems like a no-brainer. But will it happen? A game theorist familiar with the Prisoner’s
Dilemma would be somewhat doubtful. These
are not the purely rational players of game theory. Despotic political leaders and their
political elite more concerned about staying in power and other domestic
concerns head many of these countries. Some are also geopolitical rivals, often with
an overlay of intense religious or historical animosity. And virtually every OPEC member has a history
of cheating on production quotas.
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A number of prior posts discuss these themes in more detail. See the recent post on Saudi Arabia.