The 2014 Saudi oil policy change
Part 1: Setting the scene
Historical oil prices
Following the Second World War the 1950’s and 60’s were characterised by a long period of relatively stable, low oil prices. Competition ensured that the oil price was closely linked to the actual cost of oil on a global basis. The ease and low cost of oil transport precluded large differences in oil prices across the world. The market share of Middle East low cost production areas gradually increased. The secure supply of low cost oil greatly contributed to post war economic growth.
A sharp divide exists between this period and the period after the first oil price shock in 1973. Post 1973 prices have been systematically higher due to OPEC members limiting the production of low cost oil. Initially, oil prices were effectively set by OPEC. After the 1979 second oil price shock OPEC found, however, that there were limits to their ability to set prices. High prices led to increasing energy efficiency and new supply from higher cost non OPEC areas. Throughout the early 1980’s OPEC and its key member, Saudi Arabia, had to reduce production in order to support prices. By 1986, Saudi production had decreased to about 3.5 million barrels per day (with a total capacity of about 10 million barrels per day) and they opened up the taps. For the Saudis this has been a defining moment.
From 1986 to about 2002 oil prices were systematically lower compared to the 1973-1986 period. They did not return to the low levels of the 1950’s and 60’s, however. In the long run, a lower floor for oil prices was set by the cost of non OPEC incremental oil (significantly higher than the cost of OPEC incremental oil). Although prices may temporarily drop below this level, the resulting drop in investments will ensure that this will only occur for a limited amount of time. The limited influence of oil price on demand, as well as the time it takes for new oil field developments (of the order of magnitude of 10 years) imply that readjustments may take a significant time.
From 2002 onward oil prices returned to higher levels. The preceding period of lower prices resulted in a higher OPEC market share and hence more leeway to keep prices above the long term floor determined by the cost of non OPEC incremental oil. In addition the cost of incremental non OPEC oil gradually increased over time. Although there is no shortage of oil in general, there is a real shortage of cheap and easy to find oil in the non OPEC world. The cost of non OPEC incremental oil gradually increased from approximately $ 25 – 30 (2015 dollars) in the 1990’s to approximately $ 50 – 60 per barrel for the present day.
With the exception of a short period of turmoil related to the global economic crises in 2008 this period lasted until 2014. Again this period of relatively high oil prices resulted in relatively high investments in non OPEC oil with a threat of oversupply looming over the horizon at the end of this period. By 2014 Saudi Arabia (whose dominance within OPEC had increased over the years) faced the same choice as in the early 1980’s: defend market share or defend price? In the early 1980’s they chose to defend price. After 5 years they found that keeping oil prices at a level way beyond the cost of incremental non OPEC oil was simply not sustainable. Worse than that: it subsequently took 15 years to recover. So this time they reacted differently.
Within an often unstable Middle East Saudi Arabia has so far succeeded in maintaining its stability. A stability that should not be taken for granted given the internal Sunni Shia divisions and the strained relations with surrounding Shia countries, in particular Iran. The Saudi population has preferred handouts and stability above democracy and instability. Given the countries essential role in oil supply the U.S. and the western world have opted to look the other way when it came to human rights and religious fundamentalism. The special U.S. – Saudi relationship has eroded over time, however. The U.S. is well aware that most 911 terrorists were Saudi and is no longer dependent on Middle East oil. The Saudi government has been taken aback by the Iran nuclear agreement, the Obama administration’s lack of support for their long time Egypt ally and their limited support for regime change in Syria.
Undoubtedly the Saudi royal family has the last say in anything that matters within the kingdom but regarding oil they have a track record of following the advice of the technocrats that run the Ministry of Petroleum and Mineral Resources and Saudi Aramco. For the last 50 years the Ministry has been headed by 3 ministers only. Their strategy has been consistent: to maximise Saudi Arabia oil revenue in the long term. This is not just about price; it also involves contributing to oil remaining a key energy source for the world and being seen as a reliable source of supply. Within OPEC their dominance has gradually increased. Not only are they the largest producer but they have also consistently aimed at maintaining a spare capacity of on average about 2 million barrels per day. This spare capacity gives them the power (by no means unlimited) to act as the world’s swing producer and to preclude price spikes (due to financial crises or geopolitical turmoil). The kingdom’s strong financial situation enables them to give preference to long term goals at the expense of short term revenue maximisation.
Oil supply and demand: a precarious balance.
Numerous headlines on the present day oil glut may give the impression of a large difference between supply and demand. This is not the case; at present we see an oversupply of about 1 – 1.5 million barrels/day (with a total supply of about 96 million barrels/day). That such a limited oversupply (perhaps considered minor in other markets) can have such a large effect on price illustrates the low price elasticity for oil in the short term. Lower prices will result in some instantaneous higher demand (e.g., people driving more) but it takes time to have a more material effect (e.g., people driving more gas guzzling SUV’s instead of fuel efficient small cars). In the same way lower prices will have a limited effect on immediate production (less workovers, infill drilling, with a response time of order of magnitude 1 year) and a larger effect in the long term (less new field or play developments, with a response time of order of magnitude 10 years). Once that a field has been developed or a well has been drilled it will keep on producing (operating costs being relatively low compared to the oil price).
The large influence that a limited mismatch between demand and supply has on the oil price (especially in the absence of a swing producer) limits our ability to predict future oil prices.
Prior to mid 2014, Saudi Arabia (with varying levels of support from other OPEC members) has acted as the worlds swing producer for oil for a prolonged period of time. Oil price changes (e.g. the 2008 – 2009 price drop) are followed by changes in Saudi production within 1 – 3 months (e.g. the 2009 reduction in production). Without Saudi Arabia playing the role of swing producer the small oil price elasticity would have resulted in a much more volatile oil price.
The 2014 oil price drop (triggered by a limited amount of oversupply at the time) is due to Saudi Arabia’s refusal to cut back production and continue in their role as swing producer, in anticipation of a much larger oversupply predicted for the coming years (see below). This decision was not related to a large Saudi oil spare capacity hanging above the market. At the time Saudi spare capacity was close to the long term aspired average level of 2 million barrels / day (deemed to be the optimum compromise between maximising revenue and being able to play their role as swing producer).
Part 2: Why did the Saudis change policy?
Being the swing producer is not a goal in itself. It is a way of limiting volatility (contributing to oil being seen as a reliable source of energy) and avoiding prices that are either very low (overly hurting revenue) or very high (hurting global oil demand and Saudi market share, and in the long term likely to result in lower prices). The long term goal is to maximise Saudi oil revenue (although geopolitical considerations and internal stability provide boundary conditions).
I see a number of reasons why the Saudis decided in 2014 that it was in their best long term interest not to reduce production (a decision in line with advice from their consultants):
– a slowdown in oil demand growth, more so than initially expected. Demand forecasts, such as those provided by the IEA, have consistently been revised downwards over the 2010 – 2014 period.
– a significant increase of oil supply expected over the 2015 – 2020 period (especially if oil prices would remain high). These projects were often sanctioned in 2005 – 2010.
– the advance of unconventional shale oil production in the US over the 2010-2014 period (a game changer).
These three factors are all of a more structural, long term nature. For more short term issues (e.g., a temporary drop in demand related to a financial crisis as it took place in 2008, a temporary drop in supply due to political instability) the Saudis might well have been willing to continue in their role as a swing producer.
With Saudi decision making shifting to the hands of a younger generation the appetite for bolder steps may also have increased (e.g., Yemen military intervention). Geopolitical concerns (Russia, Iran) and long term climate concerns (in their view not more than one out of several components for expected future sluggish demand) may play a role as well but do not seem to have taken the centre stage. The unwillingness of other OPEC and non OPEC (in particular Russia) producers to reduce production made it easier for Saudi Arabia to take this decision.
1. Slowdown in oil demand growth. By mid 2014 the slowing down of oil demand growth, related to weak economic growth in Europe and China, became more pronounced. Oil demand in the OECD has been near constant for a long time due to increasing efficiency combined with limited economic growth. The slowdown in China is more significant, pointing at a gradual but important and long term change from a more rapidly growing energy-intensive economy to a more slowly growing less energy-intensive economy. This has far reaching implications for long term oil demand. At some time other Asian countries, in particular India, may experience a similar period of large energy demand growth as experienced by China over the last 15 years. This has not yet materialised in earnest and it may well turn out that a less well managed Indian economy may not be able to replicate what happened in China. For the long term future, it is becoming increasingly clear that climate concerns (and the resulting advance of renewable sources for power generation, electric vehicles) will affect demand.
2. Oil supply expected to increase significantly in 2015-2020. Global upstream oil and gas investment increased from about 250 billion dollars in 2000 to close to 700 billion dollars in 2013. This investment cycle started in the early 2000’s and boomed from 2010 onwards. In spite of all the problems oil and gas companies have been facing regarding reserves replacement these efforts did eventually bear fruit; partly in the form of reduced decline rates for existing fields and partly in the form of new developments (deepwater, oils sands). Whereas the first component tends to have a shorter lead time in between FID and production, the second component tends to have a much longer lead time (of the order of magnitude of 10 years).
A 2012 bottoms up analysis of worldwide upstream projects (Maugeri, 2012) showed that, assuming a 2020 Brent Oil price higher than $ 70 per barrel, 2020 liquids production capacity was expected to increase to over 110 mb/day (from about 93 mb/day in 2010). The largest increase in production was expected in the US, Canada, Brazil and Iraq. This estimate took into account technical and political risk factors (the unrisked estimate being over 130 mb/day) and should be seen as a best estimate at the time, with a large uncertainty band around it (depending on the oil price, cost levels of the oil service industry, political stability in various countries, etc). Nevertheless it started to become increasingly clear that for a continuation of the high oil prices of 2010 – 2014, and potentially even for a moderate oil price of $ 70 a barrel, a severe oversupply could exist by 2020 (the average yearly growth in oil demand needed to keep up with the base case oil supply was 1.6 %; in excess of the average observed growth over the last 20 years).
A similar analysis by Rystad Energy (2014), based on their proprietary UCUBE database (a database of existing and future oil producing assets), also pointed to higher growth of supply, compared to demand, in the 2015 – 2020 period. Other consultancy firms have produced similar, proprietary, analyses.
3. US shale oil production has taken off. The most remarkable component of recent oil supply growth has been the unprecedented growth of US oil production – solely due to shale oil production.
Fraccing has been practiced in the US since the 1940’s. The first large scale attempts at shale gas production were in the 1990’s in the Barnett shale in Texas by a small independent company (Mitchell Energy). It is only since 2010 that shale oil production from fracced horizontal wells has really taken off. The key contributing factors have been:
– A prolonged period of high oil prices
– US legislation, with mineral rights being privately owned
– Funding readily available to smaller independent producers, at a relatively small cost
– Sweet spots for shale oil production known from the large numbers of existing wells
– The existence of a large, relatively low-cost and knowledgeable service industry
– Public acceptance of the industry (in particular in key shale oil production states such as Texas)
From a technical point of view this has been a remarkable achievement. The gains in efficiency and well productivity have been impressive.
Shale oil production has a number of characteristics that are markedly different from the mainstream oil and gas industry:
– The shale oil industry is using manufacturing-like processes. Many wells are drilled / fracced using the same process in similar locations. As with many processes that are often repeated: this eventually results in strong productivity gains.
– Oil in place is less of a limiting factor compared to conventional developments. Vast amounts of oil in place exist. Oil in place in specific sweetspots may be a limiting factor but so far increased efficiency has beaten limited amounts of oil in place in the sweetspots. The verdict is still out on how this will continue in the future.
– Decline rates for shale oil wells are much faster, with on average about 60 % of total production achieved in the first year of production.
The success of the US shale industry will be difficult to replicate but it is not a given that a similar take off of production will not take place in other parts of the world, at some stage (e.g., Argentina, China). Once that a critical level of production, experience and service industry activity has been established it will be virtually impossible to stop. The rapid increase of shale oil production (in combination with more general supply and demand issues) has been a very worrying development for Saudi Arabia. It is important for them to stop this rapid increase. For that they are willing to accept low oil prices in the short term. In the longer term it may preclude a sustained period of prices in excess of $ 80 – 100 per barrel. Such high oil prices would result in a renewed explosion of US shale oil production and, even more worrying, would increase the scope of shale oil production in other parts of the world.
This is not (just) a Saudi war on US shale oil production. It is high cost production in general that needs to be reined in. If anything it is now a battle between US shale production and other high cost production areas, be it Canadian oil sands, deepwater, the Arctic or conventional mature fields (e.g., North Sea).
Part 3: Will Saudi Arabia succeed?
In order to (gradually) go back on their current policy it is expect that the Saudis would like to see:
The arrest of the rapid growth of US shale oil production
Global supply to have fallen below demand and inventories to have reduced to – or at least starting to approach – average long term levels
Confidence that a sufficient number of projects have been cancelled so that future oil supply is unlikely to exceed demand in the longer (5 – 10 years) term.
US shale oil. The figure below gives a forecast for shale oil production, as made in late 2014 by Rystad Energy. It illustrates the high sensitivity of shale oil production to oil price (rapid decline rates of existing production, short lead times for new production). Although I feel that lead times tend to be under estimated by many analysts (significant time is needed to secure funding, to hire or lay off rigs and fraccing crews) it is clear that shale oil is faster to respond to changes in oil price than the conventional oil industry. The actual 2015 U.S. shale oil production is quite close to this late 2014 forecast (for the oil price as it eventually materialised). Within a single year, the low oil price has indeed resulted in the arrest of shale oil production growth (reducing oil production by approx 2 million barrels/day compared to pre oil drop forecasts).
Nevertheless 2015 shale oil production has been quite resilient. No massive wave of company bankruptcies has taken place. A number of factors come into play:
– Cheap funding continues, be it to a lesser extent. Bankruptcies and fire sales of assets are in no one’s interest. Hence there has been a tendency to be rather lenient regarding rollover of loans and reserves re-determinations (Oil and Gas Journal, October 2015).
– A significant part of 2015 shale oil production been hedged (for approx 50 % of production of smaller companies, for prices anywhere in between $ 60 and $ 100).
– Reduced drilling and fraccing costs, faster drilling (poor performing rigs being the first to be laid off).
– More focus on the best plays and sweet spots.
– Land lease cost being sunk cost, there is often still an incentive to drill in order to minimise losses
– A gradual reduction of the number of drilled but uncompleted wells
2016 will be a much more difficult year though. Continuation of funding will be more difficult and expensive. Hedging of 2016 production at attractive prices is much less prevalent. At some stage companies may run out of their inventory of drilled but uncompleted wells. Surviving without any drilling and fraccing of any new wells (“zombie companies“), just waiting for the oil price to recover, may at some stage be no longer sustainable. The December 2015 oil price drop below $ 40 per barrel does not bode well for 2016 prices and oil shale production.
Strong productivity gains have materialized over the last few years in the US shale oil industry. For some plays (Eagle Ford and Bakken in particular) these gains may now finally have reached a plateau.
Other non OPEC production. A recent Rystad Energy analysis (based on a global database of fields and potential future assets) as shown in the figure below confirms that a continuation of current low oil prices in the long term is unlikely – given the resulting drop in non OPEC supply (and assuming no dramatic surprises on the demand side). It illustrates the significant time between investment cuts and the resulting lowering of oil production. It also illustrates how severe the eventual production drop will be. A revised supply forecast (late 2015) from McKinsey for 2025 production is in line with the Rystad work.
In these forecasts a smaller supply growth from new projects is apparent across the board. The biggest reduction seems to be in new production from oil sands. 2010 cost curves still saw similar break even costs for shale oil and oil sands. 2015 cost curves have significantly lower break even costs for shale oil. It is striking that Exxon Mobil, the major with probably the best track record for capital discipline and project execution, is hardly active in oil sands, cautious and reluctant to go ahead with large deep water projects, but keeping up its investments in oil shale (in particular in the Permian Basin).
Monitoring of upstream industry investments indeed confirms that the flow of FID’s for new projects has indeed been reduced dramatically. Throughout the world many projects that had not yet passed FID have been put on hold (and in addition a few projects that had passed FID, such as Shell’s Carmon Creek oil sands project). Upstream industry investment is down by approx $ 220 billion in 2015, compared to pre price drop estimates (WoodMac, September 2015). With December 2015 oil prices below $ 40 per barrel, the 2016 drop will almost certainly be higher, potentially by as much as $ 500 billion (Financial Times, December 2015 (subscription needed)). This will have a significant impact on production in 2020 and beyond but has a much smaller immediate effect. The short term impact has to come from a further reduction in US shale oil as well as a faster decline of the production of conventional assets (reduced infill drilling and workovers).
Saudi Arabia’s strong financial position (net foreign assets of about $740bn (mid 2014) and minimal debt) has given them a good starting position for a period of low oil prices. It will take approximately 4 years before they will start to take on a net debt (debt greater than foreign assets owned). They have the financial resources (and in all likelihood the determination) to see this through.
The resilience of US shale production so far and the significant time it takes for ongoing investment cuts to result in lower production imply that supply and demand are only expected to approach a balanced situation by late 2016 or early 2017. Throughout 2017 and 2018 non OPEC supply will start to drop at increasing rates as the fallout of the current investment cuts becomes more material. It thus seems likely that the Saudi objectives will be reached sometime 2017 or 2018. Oil prices will recover but the exact timing and magnitude are uncertain. Saudi Arabia’s preference may be that oil goes to a $ 60 – 80 range: sufficiently high to keep up non OPEC production (with field declines being compensated by the best of deepwater and US shale oil) and sufficiently low to keep a lid on shale oil production on a global basis. New oil sands projects and the highest cost mature provinces (North Sea) will continue to struggle.
Lower than expected demand as well as higher than expected Iraq and Iran production may keep oil below $ 60 per barrel for longer. Iraq/Iran production is a key source of uncertainty for oil prices in the next 2 – 3 years. Unlike high cost oil, this production cannot be reined in by the current low oil prices. Eventually the non OPEC production drop caused by current investment cuts will become so severe that prices will have to rebound.
Instead of staying within a more sustainable $ 60 – 80 USD range, oil prices may overshoot again prior to 2020. The small current oil production spare capacity and the severity of the current investment cuts increase the probability of this scenario.
A system change after which oil prices converge to the price of incremental low cost OPEC oil instead of converging to the price of incremental non OPEC oil seems very unlikely. It is not in the interest of OPEC for sure. It is not in the interest of the developed world as it is likely to lead to a dramatic drop of oil company stock prices and it will severely hamper the transition to a lower carbon world.
The Saudi efforts have a good chance of succeeding. They have been much more pro-active than in the 1980’s; not waiting for market share to collapse due to high prices. No excessive Saudi spare capacity exists at the moment (if anything it is lower than the long term average following a moderate increase in production in early 2015). The price of non OPEC incremental oil is significantly higher now. They seem determined (and have the financial resources) to see this through 2016. By 2017/2018 they should have made sufficient progress to let prices rebound. Should this require a limited drop in oil production then they will probably try and share that with other OPEC producers and Russia (with better chances of success than in 2014). Until that time they should give no early signals of a change in course, in order to maximise the drop in current and future non OPEC supply. This would leave Saudi Arabia with a much improved starting point for the challenging years ahead with likely long term limited demand (reduced economic growth, increasing energy efficiency and the fallout of climate concerns).
The current upstream investment cuts not only reflect lower oil prices but also pressure from shareholders to safeguard dividends. In a more uncertain world (geopolitical, climate concerns, Saudi policy changes) oil majors will be more reluctant to go ahead with expensive long term projects (oils sands, deepwater). Shale oil has the advantage that is more nimble, easier stopped and started with individual projects of much lower costs. Maximising value (in what is increasingly seen as a sunset industry) will take over from replacing reserves.
Significant volatility in oil prices is there to stay. The world will likely face a prolonged period of relatively low demand (reduced economic growth and energy intensity, climate concerns leading to CO2 pricing and increased support for renewables), giving a long term downward pressure on oil prices. To what extent will renewable power generation and electric vehicles take of? Reserve replacement outside of OPEC remains a challenge for oil companies, giving a long term upward pressure on oil prices. To what extent will shale oil production take off outside the U.S.?
In the meantime instability in the Middle East remains a source of concern. More intense Sunni – Shia divisions, mass youth unemployment and the partial US withdrawal from the region (the US now being close to energy independence) all play a role here. Will Saudi Arabia itself remain stable, now that the long reign of King Abdullah has ended and caution and diplomacy seem to have been replaced by assertiveness (and perhaps paranoia)? Will the current crown prince and deputy crown prince fall out? Severe supply disruptions and resulting price hikes are conceivable. On the other hand: what happens if Iraq and Iran low cost production really takes off in earnest? In the long term this could result in OPEC having three key members instead of one. Will these three countries be able to reach an agreement to limit their production? If not then we could see low oil prices for real.
In the light of limited future oil demand growth as well as the rapid recent increase of US shale oil production and the expected increase of conventional oil production (following years of high investment) the 2014 Saudi policy change seems perfectly sensible. It is consistent with their long term strategy: to maximise oil revenues in the long term.
Defending oil price at a level much higher than the cost of incremental non OPEC oil is simply not sustainable in the long run. As in the 1980’s, this would only result in a reduction of market share followed by a more prolonged subsequent period of low oil prices.
Saudi Arabia has the financial resources to continue the current policy for several years. It seems likely that by 2017 or 2018 they will have achieved their short term goals: supply to have fallen below demand, a start of inventory reduction and confidence that sufficient projects have been cancelled so that supply is unlikely to exceed demand in the longer term. By that time they may aim for a $ 60 – 80 per barrel bracket.