Why Saudi Arabia Won’t Cut Oil Production

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Price war to the bitter end?

By Nick Cunningham, Oilprice.com:

Nine months after OPEC decided to leave its production target unchanged and pursue market share instead of trying to prop up prices, the group is facing a set of complex problems and decisions going forward.

At first blush, the collapse of oil prices and the resiliency of U.S. shale appears to hand OPEC, and its most powerful member in Saudi Arabia, a stinging defeat. U.S. oil production has leveled off but has not dramatically declined. Meanwhile, oil prices are at their lowest levels since the financial crisis and the revenues of OPEC members have fallen precipitously along with the price of crude.

All of that is true, and in fact, Saudi Arabia is under tremendous pressure. The Saudi government is considering slashing spending by a staggering 10 percent as it seeks to stop the budget deficit from growing any bigger. The IMF predicts that Saudi Arabia could run a budget deficit that amounts to about 20 percent of GDP.

The pain is manifesting itself in different ways. Not only will the Kingdom have to cut spending, but it has also turned to the bond markets in a big way. Low oil prices have forced Saudi Arabia to issue bonds with maturities over 12 months for the first time in eight years, raising 35 billion riyals (around $10 billion) so far in 2015.

At the same time, the currency is coming under increasing pressure. Saudi Arabia pegs the riyal to the dollar at a rate of about 3.75:1, but speculation is rising that the currency may need to be devalued, given that the oil producer won’t be able to defend that ratio indefinitely. On one-year forward markets, the riyal has already weakened to 3.79, according to the FT. That forced the government to issue a statement, saying that the Saudi Arabian Monetary Agency “is committed to the policy of pegging the Saudi riyal with the American dollar.” But if oil prices do not rebound, the government will have to continue to draw down on its foreign exchange in order to keep the currency steady.

All the damage inflicted upon Saudi Arabia has the world looking back towards Riyadh, especially after oil prices crashed on “Meltdown Monday.” The markets are trying to figure out if Saudi Arabia may switch tactics in order to stop the crash from worsening.

Pressure is actually the greatest within the oil cartel. Algeria’s oil minister wrote a letter to OPEC’s secretariat requesting action, although the letter stopped short of a call for a production cut. Months earlier, before OPEC’s last meeting in June, Venezuelan officials pressed for a change in strategy to shore up oil prices. Venezuela is arguably the worst off member, as its economic and financial crisis worsens by the day.

More recently, Iran’s oil minister said that his country would increase oil production “at any cost,” but also supported an emergency OPEC meeting before the scheduled summit in December in order to discuss the group’s strategy. More and more members are clamoring for a cutback in the cartel’s production.

If Saudi Arabia’s strategy of pursuing market share has not worked, and even its colleagues inside OPEC want a policy change, perhaps Riyadh would reconsider and now decide to restrict production in order to boost prices?

That is more wishful thinking than a likely possibility. There is little chance that Riyadh would retreat now just as the worst pain is really beginning to set in for rival producers. Sure, Saudi Arabia is suffering from low prices, but its competitors are hurting worse. U.S. oil production, after years of blistering growth, has not only ground to a halt, but has started to decline. Output peaked in March at 9.69 million barrels per day (mb/d), dropping to 9.51 mb/d in May (the latest month for which accurate data is available). In all likelihood, the decline has picked up pace in the intervening months.

And more to the point, U.S. oil production will continue to decline the longer Saudi Arabia holds out. Several companies have already gone bankrupt, and more are no doubt coming down the pike. That will allow Saudi Arabia to achieve its goal of holding onto market share, and letting prices adjust on the back of rival producers.

To highlight this point, Saudi Arabia’s decision to cut its budget should be seen not as evidence that it is buckling under crushing weight of low prices, but that it is in the game for the long haul. It is shrinking its budget to fit a world of depressed oil prices, positioning itself to ride the wave as far as it goes. Cutting spending is actually a signal of the government’s resolve in regards to its current oil strategy, not a sign of wavering. By Nick Cunningham, Oilprice.com

Or is it a bet gone haywire? “This requires more patience” – the Saudi Central Bank. Read… The Saudi Oil Price War Backfires

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  16 comments for “Why Saudi Arabia Won’t Cut Oil Production

  1. michael
    Aug 27, 2015 at 12:52 am

    It is a race to the bottom.

  2. Pookchai
    Aug 27, 2015 at 1:57 am

    Deflationary Collapse Ahead?

    Both the stock market and oil prices have been plunging. Is this “just another cycle,” or is it something much worse? I think it is something much worse.

    Back in January, I wrote a post called Oil and the Economy: Where are We Headed in 2015-16? In it, I said that persistent very low prices could be a sign that we are reaching limits of a finite world. In fact, the scenario that is playing out matches up with what I expected to happen in my January post. In that post, I said

    Needless to say, stagnating wages together with rapidly rising costs of oil production leads to a mismatch between:

    The amount consumers can afford for oil
    The cost of oil, if oil price matches the cost of production

    This mismatch between rising costs of oil production and stagnating wages is what has been happening. The unaffordability problem can be hidden by a rising amount of debt for a while (since adding cheap debt helps make unaffordable big items seem affordable), but this scheme cannot go on forever.

    Eventually, even at near zero interest rates, the amount of debt becomes too high, relative to income. Governments become afraid of adding more debt. Young people find student loans so burdensome that they put off buying homes and cars. The economic “pump” that used to result from rising wages and rising debt slows, slowing the growth of the world economy. With slow economic growth comes low demand for commodities that are used to make homes, cars, factories, and other goods. This slow economic growth is what brings the persistent trend toward low commodity prices experienced in recent years.

    A chart I showed in my January post was this one:

    http://ourfiniteworld.com/2015/08/26/deflationary-collapse-ahead/

    • brian
      Aug 27, 2015 at 5:05 pm

      Just goes to show that even demand has limits; I guess the peak oil guys were right afterall, its just that its not the planets supply that has peaked but mankind’s ability to consume it that has. Interesting.

  3. MC
    Aug 27, 2015 at 3:58 am

    The Saudi (and their Gulf allies/vassals) knew fully well they were in for the long haul.
    The beauty of their strategy is that it’s slowly bleeding the shale patch white instead of causing one massive crash: that way they’ll be able to avoid any bailout that may throw their plans into disarray.

    The Saudi may have a thousand defects but they aren’t stupid: they know well what will crush the shale patch is the inability to service the massive debt built up in the 2009-2013 time frame, before innovations that cut costs like pad drilling came into widespread use. They also know as the value of known reserves drops with the price oil, debt servicing through more debt will become progressively more expensive as risk creeps back into the system. Anything that helps drive yields upward (even if the US Federal Reserves does nothing) ultimately helps the Saudi cause.

    Now, don’t think Washington DC is one big fool who doesn’t see what’s going on under his nose. Treasury and State know perfectly well what the Saudi strategy is, but they cannot do a damn thing about it.
    Too much has been staked on claiming the Saudi are second only to Israel as “America’s best friend in the Middle East” and everybody knows Main Street, after having been played for fool in 2008, has grown very hostile to bailouts of any kind, especially those benefiting “big money” sectors such as banking, pharma and energy. With a hotly contested Presidential election coming up in 2016 the last thing needed is to bail out the shale patch and/or artificially prop up the price of oil to save oil companies.

  4. hoop
    Aug 27, 2015 at 6:33 am

    It seems not everybody is onboard anymore: Reserve Bank of India governor Raghuram Rajan : ”Using cheap money to tackle economic problems rather than reform must stop” http://www.bbc.com/news/business-34056740

  5. merlin
    Aug 27, 2015 at 8:31 am

    MC has nailed it. The Saudis are simply invoking a frequent Standard Oil ploy documented in the “The Prize” by Daniel Yergin. There will be a “deal” cut somewhere behind closed doors between US and Saudi to stabilize this downturn, likely military aid for a stable price per barrel range.

  6. rich black
    Aug 27, 2015 at 8:53 am

    The real game changer would be if the Saudis dumped the petrodollar. If the USA couldn’t flood the world with dollars, created out of thin air, because of its petrodollar/reserve currency status, US shale oil operations would find even their junk paper financing difficult to obtain. The Saudis have been talking to both Russia and China lately, and China has already dumped more than 1/10 of its USD reserves, since the beginning of the year. If the US lost its world currency reserve status, funding for shale oil would dry up faster than the fracked wells.

    The Saudis are very unhappy with US fracking and with the US backing of the Iranian nuke deal. The Saudis are no longer our allies, and they had pretty much already announced that on 9/11, a few years back.

  7. ERG
    Aug 27, 2015 at 9:55 am

    Stabilize oil prices? Have no fear, it is presently in the process of stabilizing all on its own…at $35/bbl.

  8. Michael Gorback
    Aug 27, 2015 at 11:42 am

    As I’ve mentioned before the Saudis gave seen this movie before. The last oil catered they cut back production to tighten supply. Unfortunately no one else did and the Saudis eventually capitulated and joined in, driving oil even lower.

    They are doing this because they have no choice. If you think they can kill shale permanently you’re wrong. The drillers may die off and their paper go to zero but as soon as the price recovers someone will pick up the pieces and start drilling again.

    This is a no-win situation for the Saudis. They have no choice but to keep pumping. That will keep prices too low, and the minute prices go back to the 70-80 range the frackers will be back.

    • Michael Gorback
      Aug 27, 2015 at 12:32 pm

      Fixed some typos. Hopefully this will make more sense.

      “As I’ve mentioned before the Saudis have seen this movie before. The last time oil cratered they cut back production to tighten supply. “

    • Night-train
      Aug 28, 2015 at 4:46 am

      I think how soon those prices reach $70-80/bbl is the key to if and when the shale oil activity picks up. If the Saudis are in for the long term and keep prices down for 2 or 3 years, much of the underpinnings of the industry go away. Rigs are scraped. workers go away. Sure, get the price high enough and it can all come back, but at a more measured pace. New rigs can be built. But getting the intellectual capital back is a little harder. Many engineers, geophysicists and geologists, if burned, will not come back. And while university engineering and geology departments put out well educated people, to be oil field qualified takes a few more years of hands on oil patch education. And since most of the shale oil plays were likely only marginally profitable in the $70-80/bbl range, the reemergence price may be $90-100/bbl.

      • merlin
        Aug 28, 2015 at 6:56 am

        The scrapyards from the 1980s bust have never gone away. There are still hundreds of acres of E&P boneyards on the north and south sides of the turnpike between Tulsa and OKC. I am sure you will find others in all the producing states. Ghostly voices mutter and moan thru these yards ‘Oh Lord, give us one more boom and we promise not to blow it” He did, and we blew it anyway.

        https://www.google.com/maps/place/Tulsa,+OK/@35.7491897,-96.6965446,147m/data=!3m1!1e3!4m2!3m1!1s0x87b692b8ddd12e8f:0xe76910c81bd96af7

        • michael gorback
          Aug 28, 2015 at 9:50 am

          There is a difference in technology. The old conventional wells are very expensive to start back up and in many cases they were so marginal they were never economically viable to salvage. Fracking is much easier and cheaper to restart.

      • michael gorback
        Aug 28, 2015 at 9:56 am

        The engineers and geologists will come back. Always have, always will. They came back even though oil was below $20/barrel in the 90s. Somebody was there pumping oil at $120 or more a few years ago.

        I live in Houston near NASA and have watched the ebb and flow of engineers in and out of NASA during the fat and lean times depending on government programs and budgets. Same with the oil guys.

        • night-train
          Aug 29, 2015 at 3:51 am

          Some engineers and geologists will come back. Some won’t. I know some who came back after the 90s and others who did not. I had some nice offers in 2010, but chose to retire instead. Couldn’t see moving to Houston, when I could kick back and watch the world go by. Besides, it was for a shale play. That is the geological equivalent of watching paint dry. Now, if we can get into Cuba, I might be tempted. Some exciting geology there.

          I respectfully disagree with your contention that the shale plays are different technology. They are just fracking on a massive scale. The rest is just standard oil patch tech. No one knows how successfully the shale wells will be able to be brought back online, should they be shut-in for a lengthy period. I realize this view is contrarian to Houstonians. But it is based on objectivity, not that I drink the Kool-Aid because my job depends on it. These plays are huge money sinks with little sustainable profitability. But, it’s not my money, so if the operators can find more investors, good luck to them.

        • Michael Gorback
          Aug 29, 2015 at 6:24 am

          Night train check out new uses for old technology currently being implemented for fracking: Cinco de fraco and octofrac. Refracking costs far less than drilling.

          I’m not saying refracking is without problems. Just one example of how fast the response is moving.

          The people will be there when needed. You were at a different career point.

          Meanwhile the Saudis are borrowing money to protect their FX reserves. The lower the price of oil the shorter the fuse on that setup. They HAVE to ride it out. The US can walk away and come back. Oil isn’t THE industry in the US.

          Where the Saudis can hurt us is in the fact that they’ve broken the petrodollar, although that’s not a goal but a side effect. That plus China selling Treasurys to manage the yuan (also a secondary effect) is far more significant – the equivalent of quantitative tightening into a still weak quasi-recovery.

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