Director’s Blog VII – Mission (almost) Accomplished
A little over one year ago, the pandemic was a new phenomenon, one which spawned a briefly negative spot price for crude oil. This unprecedented event was the result of crude piling up at the Cushing, Oklahoma where West Texas Intermediate (WTI) is priced. The proximate cause was the pandemic-induced drop in oil demand. A complementary driver was a Saudi-Russian price war which flooded the market with supplies even as demand was dropping like a stone. At that time, we attempted to unravel what was going on. Our conclusion – that the Saudis, aided by Russian hard headed tactics, had decided then was the moment to strike hard at America’s shale revolution. The outcome sought – a recovery of Saudi pricing power in world oil markets. A year later, it is (almost) mission accomplished.
One year ago we wrote as follows:
Let us discard the assumption that the Saudis decision for price war was just emotional; even if emotion was involved, the Saudis have long experience and shrewd judgement about oil markets. By now they can see that the opportunity to seriously cripple U.S. shale production is at hand. Moreover, they will need more than help from the Russians to balance a cratering oil demand scenario. Letting loose a precipitous decline in U.S. shale production will lend the additional help needed with the added dividend of deterring U.S. players from venturing quickly back into growth mode…
For sake of argument, assume that global oil demand stabilizes at 90 MB/D, 10 MB/D below its recent run rate. Assume also that 3 MB/D of U.S. shale production goes away over 12-18 months and 5 MB/D of natural decline and underinvestment occurs elsewhere. With these events in tow, the Saudi/Russians could begin to view what they desire, a scenario where their cuts could balance the market, there would be little production response outside their borders and where prices could then be driven by demand recovery. At that point, from their perspective, coordinated cuts would make sense. $70-80/B oil would be in sight.
This forecast was not far from wrong. According to the U.S. Energy Information Administration, U.S. oil production peaked at 13.1 MB/D during the week of February 21-28, 2020. It bottomed out at 9.7 MB/D during the week of February 19, 2021. As of late April, 2021, one-month WTI is priced around $61/B.
More fundamentally, pricing power has shifted from West Texas back to the princes in Riyadh.
Given the extent to which the U.S. shale revolution upended OPEC’s dominance in world oil markets, the Saudis could hardly ask for a better turn of events. Not only has U.S. shale production declined, but powerful tides have turned against its rapid recovery.
Consider the following:
So, intentional or not, the Saudis, OPEC and their Russian sometime allies (OPEC+) have achieved something that eluded them for a decade – putting into question the U.S. frackers ability to offset cartel supply management. Right now, the Saudis can raise prices by taking crude off the market or drive them down by supplying more barrels. For proof look no further than the surprise 1 MB/D Saudi voluntary cut last December; it propelled Brent prices north of $60/B.
What will the Saudis do with this recovered strength? Moreover, will their power last? Posing these questions lays bare a rather complicated matrix of issues which Riyadh will be balancing. How well they manage this effort will determine whether oil prices stay in a relative comfort zone for some years or overshoot to levels that will unhinge a number of other issues.
The view from Riyadh starts with an assessment of the current market balance. OPEC+ has about 8 MB/D of spare capacity, including Iranian oil under sanctions. End-2020 demand of 91 MB/D is forecast to surge to 97 MB/D as economies recover this year. There will be some recovery in U.S. production, so add another 1 MB/D to available supplies. From this perspective, the market looks balanced. A Saudi-led OPEC + can feed spare capacity into the market as demand recovers. They also can determine the price level at which to make these supplies available.
There are, however, two big imponderables which cloud this neatly balanced picture. How far and fast will demand come back? Right now, there are factors retarding a rapid recovery in demand, i.e. slow vaccination rollouts in Europe and the developing world plus new variant COVID breakouts in places like Brazil and India. However, when these episodes run their course, demand is likely to come back with a rush. There will be all this pent-up demand for normal living and the return of travel. The world is also awash in financial liquidity. People have money to spend and suppliers are feeling both cost pressures and the pinch of foregone sales. Spending, possibly to unprecedented degrees, may be the result, and with spending comes renewed demand for immediate energy and mobility, which means oil & gas. Will this happen in 2021? The guess here is that it will begin this year, and 2022 will be a barn burner.
A second imponderable concerns supply depletion. Every year existing oil fields decline by an average of 6-8%. In today’s world, that means 5-7 MB/D of capacity goes away. Of course, new fields are always in the process of coming on stream. However, new capacity is a function of prior year exploration successes and development investment. Before 2020, this activity was muted outside of the U.S. Last year brought further and dramatic pullbacks across the board. Moreover, whole countries, Venezuela, Iran and Mexico come to mind, have been starved for investment for years. Their ability to maintain production, let alone increase it, is very doubtful. In short, net depletion outside the U.S. could be a bigger factor depressing supply than has historically been the case.
Thus, the oil markets are operating with an assumption of multi-year balance managed by OPEC+/Saudi judicious injections of spare capacity. To this must be added a major sensitivity case – demand surging faster than expected to levels higher than 2019, combined with slower recovery of non-OPEC supply. How might the Saudis respond to this scenario?
The Saudis have been masters of the oil pricing game for decades. Their long experience has equipped them with perspective, judgment and subtlety. They also understand that being transparent is not in their interests; having the market uncertain and guessing what they will do only magnifies their influence on prices. With all this said, the Saudis will consider four questions when charting their strategy:
At first glance the answers to these question seem straightforward. They are not. It is in the complexity of the answers that one finds the keys to what the Saudis may actually do.
Take the first question. The answer would seem to be the higher, the better. However, the Saudis have budgetary requirements each and every year. The oil price boom/bust cycle plays havoc with their internal stability. Thus, the Saudis are interested in the ‘right’ budgetary price level, i.e. one that not only pays the bills but is sustainable. It is widely reported that the Kingdom needs $80-90/B oil to stop drawing down their financial reserves. Let us assume that the Crown Prince’s economies and diversifications allows the Kingdom to target the low end of this range. Would an $80/B crude price be sustainable?
This question turns principally on the reactivation of U.S. shale production, and secondarily on whether higher prices trigger a recovery of exploration/production in oil regions outside the U.S. Past price spikes, e.g. 1980, 2007, triggered new supplies which robbed the Saudis of pricing power and eventually produced price busts. Today, there is no question that the U.S. has the potential for much higher production. Recent studies looking at available resources and breakeven economics conclude that U.S. production could recover to 14 MB/D by 2023 if crude prices reach and remain above $70/B. If prices rise to $90/B, some 16 MB/D of production could be the result. These projections assume many things, e.g. that U.S. producers assume these price levels are ‘here to stay’ and are thus supportive of investments which will need some years to pay back.
How realistic are these forecasts? For starters, the economics at $70/B do provide incentives. Production costs in places like the Permian have declined, and a $70/B benchmark price today provides something like a 100% cash margin. This level of incentive would seem to suggest a rapid shale recovery, but there are other questions to consider. How ready and able are U.S. shale producers to return to aggressive development? How much will they be deterred by the hostile stances of Wall Street and the Biden administration? What capabilities can the services companies offer to enable an aggressive recovery; can the service sector rebuild its capacity over what timeframe?
Each of these questions could merit a book, but some clues allow for educated guesses. The Biden administration took very symbolic actions against the industry in its first days but was careful not to draw red lines nor attack the industry head on. They have not attempted to outlaw shale production nor regulate the industry to death. They did not attack LNG or crude export projects. Instead, the administration focused its efforts and political capital on redirecting investment into oil and gas substitutes, e.g. renewables, storage and EVs. Moreover, the biggest threat to its current gigantic budgetary gambles is renewed inflation. Prompting run-away oil prices is no way to avoid an inflationary surge. Taking all this into consideration, the Biden administration is more likely to use higher oil prices to justify its infrastructure spending as opposed to taking actions that curtail U.S. production – which actions would only feed the inflation cycle threatening their whole agenda.
As for Wall Street, ESG narratives notwithstanding, there is plenty of market cash looking for returns and contrarian investors not infatuated by the idea of demonizing the industry that heats their homes and powers their vehicles. If they believe $70/B is here to stay for at least several years, there will be funding unlocked for producers. That means we have to look to U.S. producers themselves for clues as to their appetite for all out development.
There is a level of production that can easily be reactivated. DUCs (Drilled, Uncompleted wells) can be completed and currently available services mobilized for action. If WTI prices rise to $70/B, a return to 11-12 MB/D over 8-12 months looks feasible. At that point the industry would look to see what’s happening to costs, margins and the political landscape. Assuming the Biden administration behaves as outlined above, 13-14 MB/D by 2023-24 would be feasible.
Do the Saudis want to allow this to happen? For multiple reasons, the Saudis probably don’t want to see $100+/B prices. That price level is likely to trigger an all-out consumer government assault on oil demand, one which could involve the permanent destruction of demand embodied by EV mandates and ICE bans. If global demand recovers at a pace manageable from OPEC spare capacity and the recovery of production in places like the U.S., the Saudis can live with the return of U.S. shale production. Guarding against a demand spike that drove prices towards $100/B would seem to be their greater concern.
Iranian complications are another factor incentivizing the Saudis to keep prices lower. An oil price spike would intensify pressure on the Biden administration to bring Iranian barrels back into the market. This in turn could not only begin restoring Iranian finances but could promote an ultimate nuclear deal little better than the one negotiated by the Obama administration. Neither of these outcomes is in the Saudis interests and each would be seen as an immediate danger to Saudi security.
Taking all this into account, it is more likely than not that the Saudis will favor keeping prices below $70/B for the duration of 2021 and into 2022. Doing so will help avoid three things the Saudis wish to delay: 1) the most expansive form of the Biden administration’s ‘green’ program; 2) a weak Iranian nuclear deal that brings more barrels on the market, and 3) a rapid reactivation of U.S. shale production. In the short run, the Saudis, in conjunction with their Gulf allies and eager producers like Iraq, have the spare production to accomplish this. They also have the capacity to add more barrels at given moments than the market needs. Do doing so, the Saudis can administer small ‘shocks’ to the market. This will perpetuate fears and postpone the crystalizing of expectations that higher prices are sustainable.
Once these near term negotiations, Biden vs. Congress and U.S. vs. Iran, are out of the way, the Saudis can let the market settle higher. If at that point demand is roaring ahead of supply, they may conclude that $70-80/B is needed to coax forth the shale production needed for stability. Crude prices at these levels are not hard to imaging for late 2022 into 2023-24.
There is one other factor to watch – the global refining balance relative to crude supply. One reason oil prices peaked at $145/B in 2007 was that virtually all remaining spare crude production was heavy oil. At the same time, global refineries were tapped out in terms of capacity to process heavy crudes. This led to cutthroat bidding for light crudes, which of course drove benchmark crude prices to new levels. Will this happen again? This is hard to say. Much U.S. shale production is light to ultra-light. Much heavy crude production has declined in places like Mexico and Venezuela. Canadian tar sands seem bottlenecked for now. All this bodes well for prices not spiking because of refining constraints. That said, if the world again gets down to ~2 MB/D of global spare capacity, it likely will be Arabian Heavy on standby. Will global cokers and hydrocrackers then be full?
Like all forecasts, this one is fraught with exposure to contingencies and ‘Black Swans.’ Will the global recovery come faster or slower, will Biden’s program get passed, who wins various elections, etc.? The purposes of this analysis, however, are several. Its first aim is to stipulate that for now, OPEC+ and especially the Saudis are back in the driver’s seat. Second, it serves to posit the critical questions which help define the Saudi national interest for the next several years. Answering these questions can provide clues as to how the Saudis will act as oil markets evolve. Third, it is to highlight a ‘shelf’ in the timeframe across which oil prices need to be analyzed. The next 12-18 months will be shaped by demand recovery, the Biden administration program and the Iranian nuclear negotiations. Ample spare capacity gives OPEC+ and the Saudis the means to respond to demand while keeping prices down to avoid ‘undesirable’ US/Iranian outcomes. Once those three near term contingencies are clarified, the Saudis will be freer to target higher prices consistent with their longer term objectives of internal stability and maximizing the value of their oil reserves.