'The Saudis want to destroy US shale'. This statement has been repeated by every talking head, market analyst, commodity strategist and oil industry leader over the last year and a half. Most surprisingly, I have heard this statement repeated by oil and gas professionals who should know better. I say 'know better' because even a perfunctory level of critical analysis can prove this statement to be untrue. In this article I attempt to dispel common myths about why Saudi Arabia has undertaken its strategy over the last year and a half, and how investors should approach investing in this sector in the near to medium term. This is an analysis of the Saudi strategy as it relates to oil markets.
What is Saudi Arabia?
This may seem like a strange question but it is a key element in understanding global energy markets. On the surface, Saudi Arabia is a Gulf monarchy with the largest clout in global oil, including de-facto leadership of OPEC. On a deeper level, Saudi Arabia is a Sunni Muslim kingdom run by an extended royal family. Deeper still, KSA (Kingdom of Saudi Arabia) is a client state of the US and has deep and binding ties to Big Oil and Washington DC. (Big Oil refers to the western supermajors such as Exxon and BP; Washington DC refers to the American political and governmental establishment). KSA has always been the prime mover in the affairs of OPEC, deciding to stabilize oil markets when it saw necessary. KSA also accepts American political hegemony in the Middle East in exchange for military and political support. KSA's acceptance of American currency in return for its barrels of oil is the foundation of the petrodollar. Nominally, a petrodollar is defined as a US dollar earned by the export of oil or gas. In my opinion, the petrodollar should be seen as the bedrock of the modern economy as it is currency backed by the true driver of modern civilization - oil. There have been countless books written about each of these statements above, so I won't go into too much detail, but suffice it is to say that KSA has close ties to DC and through its acceptance of US dollars for its oil, it facilitates US economic preeminence.
No discussion of oil and Saudi Arabia is complete without a healthy dose of politics. I'll go through some of the more common assertions and evaluate them based on the facts. The intent here is to stay away from unsubstantiated conspiracy theories.
'Saudis want to harm Iran'. True, although harm might be a strong word. I believe the idea is containment. Iran has had a string of geopolitical successes over the past 10 years and wields considerable influence in the region through its proxies. Iraq for all intents and purposes is now an Iranian client state. Syria (the rump controlled by Assad) is another client state. Lebanon is a divided country but the largest political and military force in the country, Hezbollah, is an Iranian proxy. Most recently the war in Yemen between Iranian-backed Houthis and Saudi-backed regime forces, combined with a restive Shia population in Eastern KSA has fermented a feeling in the Saudi regime of being beset by enemies on all sides. Although KSA retains the overwhelming support of all Sunni regimes in the region in its immediate vicinity, it has very few avenues to project power and contain Iran. ISIS is the wild card in this scenario and I don't claim to know who supports or funds ISIS; the only certainty is that ISIS is vehemently anti-Shia. Given this situation, the only real weapon the Saudis have is oil. With Iranian sanctions now lifted and Iran determined to gain much of its lost market share in oil markets, KSA must jump the gun and try and gain market share in Europe and Asia. In addition, if Iran is to return to the oil market with tankers full of supply, KSA would rather have Iran not get a high price for this oil.
'KSA is a pawn in a US - Russia struggle'. Mostly false. Yes, falling oil prices have taken a heavy toll on the Russian economy; however, Russia can survive this crisis. Its confrontation with the US and support for Assad in Syria are calculated steps to maintain its power in the Middle East. KSA has no long - term quarrel with Russia and will in fact cooperate with Russia when it has to. I believe that if OPEC has to regain its relevance in the future, KSA will have to accommodate Russia within the cartel. I see no reason that this won't come to pass.
For years KSA has maintained some semblance of order in the global oil market through its leadership of OPEC. Some of OPEC's attempts to manipulate the market have been semi-successful such as the embargo in 1973-74, and coordinated productions cuts in 1998-99. Most of OPEC's responses have been abject failures such as the embargo of 1967 which led to increased production in the US. Perhaps the biggest failure for OPEC, and KSA in particular, were the cuts of the mid 1980's; while KSA cut production from 10MM BPD to around 3MM BPD, all it got for its troubles was increased production from other OPEC members and non -OPEC producers. I believe this disastrous strategy which led to both revenue loss and loss of market share has shaped KSA's response to the current oil market paradigm. Rather than give up market share in a questionable attempt to shore up prices for all producers, KSA has decided it is much better for it in the long term to keep pumping oil in an attempt to maintain market share while simultaneously degrading all long term investment in marginal oil and gas projects.
Bringing order to the market
OPEC is a cartel with one dominant member. In economic theory, a cartel arises when producers agree to manage output, prices and the entry and exit of new members. OPEC served a purpose in the past when the cartel held close to 50% market share of total world production. Although cheating on production quotas has been rampant and constant throughout the cartel's history, the members could at least come together to present a united external front. Even this pretense of bonhomie was shattered in late 2014 when OPEC, under Saudi pressure, decided to not implement any production cuts. The importance of this decision cannot be understated - when a cartel decides to abandon production targets and throws in the towel on managing prices, it is admitting that the cartel no longer functions.
There have been numerous studies done on the economics of cartels - how they arise, their effectiveness and stability along with their longevity. Without diving too deeply into economic theory, it appears that OPEC at the moment is a busted cartel. KSA has rightly decided that it cannot prevent cheating by other members. KSA has also decided that another very important member of the cartel, Iran, doesn't share its goals and is in fact actively hostile towards it. The only way to re-establish any order in the cartel and the market is the nuclear option - abandon all production targets and pump away. The ultimate goal is to lower prices to a level previously thought unimaginable, in my estimation somewhere close to $15BBL. This would still be higher than the marginal cost of production for conventional Saudi oil, estimated at $5-$10BBL. (To clarify, this is just the marginal cost, not all in cost to replace every barrel used or the breakeven cost per barrel for the budget to balance.) This would be such a shock to the market that not only would marginal and expensive players be forced to exit, but more importantly the entire psychology of market participants would be fundamentally altered. Every project being considered would have to answer these fundamental questions - does this work at $40? How about $30? How long is the payback period? What upfront investment is required?
Global oil landscape
In 2014 the US overtook KSA as the largest oil producing nation in the world. While this milestone was much heralded in America, one thing to remember is that not all oil production is the same. While all Saudi production in controlled by the state through Saudi Aramco, production in the US is fragmented with hundreds of companies following their own production strategies. Globally, the list of top 10 oil producers has been fairly consistent over the past decade with movement within the list due to sanctions (Iran) or a decline in production due to lack of investment (Venezuela and Mexico). I would like to point out here that oil production should be distinguished from oil exports. While China produces almost 4MM BPD, it is not an exporter of oil as its consumption is almost 13MM BPD. On the other hand, Kuwait produces around 2.5MM BPD while consumption is only 500M BPD. I make this distinction to illustrate that oil production by itself is not sufficient to make a country a global oil power. Further to this point, calling America the swing producer in global oil is also inaccurate. A swing producer has the ability and will to take coordinated action to stabilize a market - which America does not. The swing producer in Oil markets is and has always been the same - Saudi Arabia.
It is my opinion that KSA realizes that shale plays where production can just as easily be ramped up as it is shut down, are not long term threats to their position in global oil markets. The intended target, if you can use that word, is high-cost marginal oil plays such as ultra-deepwater projects, oilsands projects and any project in general that requires high oil prices to pass economic feasibility studies. The idea is to make long-term investments, in an industry where you need very long-term investments, uncertain. Just over the last year many prominent Canadian oilsands projects have been cancelled and the industry now expects to only produce 3MM BPD as opposed to forecasts as recently as 2014 that Canada could produce up to 6MM BPD by 2030. In the same way the presal discoveries of the coast of Brazil face an uncertain future given internal troubles at Petrobras along with the difficulty of economically recovering oil at prices under $50bbl. The mega Kashagan oil project in Kazakhstan has been beset by cost overruns and is another example of the difficulties of bringing complicated oilfields online. I mention these projects to highlight the fact that it is hard enough to develop deepwater and unconventional sources of oil, without also having to worry if the economic returns will justify the cost.
Saudis can survive just fine
Not a day goes by without an article on how much this current strategy is costing KSA. Towards the end of 2014 the narrative was that KSA needs oil close to $100BBL to balance its budget and maintain domestic spending. Analysts predicted 'social unrest' and even 'collapse' if the kingdom cuts back on its generous welfare state, where citizens are promised a high quality of living in return for political loyalty. During 2015 the narrative shifted slowly towards KSA plans for 'lower for longer'. In fact, the latest Saudi budget unveiled just before the end of 2015, raised domestic prices for gas, water and electricity. KSA is also investing in natural gas as a fuel for power generation in place of oil which should free up more oil for export. The government is projecting a deficit of close to $100B or 15% of GDP. While this is a substantial number, it is also a moving target. All the doom and gloom about KSA's ability to keep its population content and whether KSA can maintain its peg to the USD misses the dynamic nature of government decision-making. The Saudi population will support the regime for much longer and through much more pain than people realize. This is not only due to loyalty or patriotism, but also due to the widespread belief amongst Gulf Sunnis that they are under siege from Iran and its Shia proxies. With regards to the peg to the USD for the riyal, the Saudis do have the ability to tap external debt markets for a considerable period of time. This source of funding should help stabilize the drawdown of FX reserves.
Money to be made?
Yes, there will be plenty of money to be made coming out of this crisis. I am also sure that plenty of money has already been made by major players shorting oil companies into the ground. My own analysis of the market and US shale names leads me to conclude that although many companies have quality assets, they will have to either sell these assets at distressed prices, negotiate with creditors or declare bankruptcy. Spokesmen for the industry like Harold Hamm like to come on TV and criticize Saudi Arabia. Most recently Mr. Hamm was on TV claiming that 'Saudi Arabia has failed to destroy us', and 'this is trillion dollar mistake'. Personally, I believe there have been many mistakes - mostly by US shale companies. For example, Mr. Hamm famously liquidated Continental Resources (NYSE:CLR) hedges in late 2014, predicting a swift rebound for oil prices- a monumental mistake and an example of poor corporate governance at CLR. Other mistakes by US shale players include overpaying for assets, indulging in unwarranted deal-making and issuing debt like there is no tomorrow. On the last point, it is claimed that the Fed facilitated this orgy of debt by keeping rates extremely low. True enough as this statement is - it doesn't absolve poor management choices. It is not just shale players who are to blame; investment bankers did their part too. But they have moved on, leaving companies with huge piles of debt and energy corporate bankers with headaches. The collapse in energy bond funds, and high-yield funds in general, over 2015 was a direct hangover from this debt extravaganza. Furthermore, 'extend and pretend' by corporate bankers will come to an end. The next round of lending reviews and base redeterminations should be eye-opening.
The people who will win from this crisis are the people who always win - the big guys. Exxon (NYSE:XOM), Chevron (NYSE:CVX), Shell (RDS-B), and Total (NYSE:TOT) - every one of the supermajors will survive and buy distressed assets on the cheap. If your horizon is very long term, then Suncor (NYSE:SU) is another oil player that will survive this crisis and come out stronger. Its position as the largest player in the Canadian oilsands combined with its strategy of buying assets on the cheap will ensure a healthy position when prices do recover. The Canadian oilpatch is in dire straits at the moment with almost all production at a loss. The recent rejection of the Keystone XL pipeline did not help industry sentiment. As an aside, it is one thing if opposition to the pipeline is based on environmental grounds, but for the US administration to claim that the pipeline would not reduce America's dependence on foreign oil is disingenuous. Canada and the US share language, culture, and a deep political and military alliance among other things. To call Canadian oil 'foreign', while technically true, is not the best way to treat a friend. The oilsands are a substantial resource, and form an important domestic source of energy in an increasingly volatile world. For this reason I believe the oilsands will continue to supply US energy needs for a very long time to come.
Prime targets in the US include companies operating in the Permian basin such as Pioneer Natural Resources (NYSE:PXD). Other more competent authors have already written about PXD. I will only highlight 3 points: semi-hedged through 2016, quality assets in the Permian and a Debt-to-Equity ratio of 30%. Other producers with quality assets include EOG Resources (NYSE:EOG) and Apache (NYSE:APA). In the near term I am staying away from all these names. No need to average down or build a position till we see actual sizable bankruptcies in the US. Whiting Petroleum (NYSE:WLL) has $5.25B in debt although it does have a decent liquidity position with a mostly undrawn revolver and no major debt coming due in 2016. Its 2018 6.5% bonds are trading at 59 cents today (Jan 16 Data from Bloomberg) which suggests the credit market views the company as significantly distressed. There are many examples like WLL in the US whose survival is now a question of negotiating with creditors and maintaining whatever cash flow they can. Even if oil sees a bounce to $35BBL or $40BBL it won't fundamentally change the future for such players. It will help with cash flow in the short term but the inevitability of steep well decline rates and maintenance capex requirements will force such companies out of business.
The purpose of this article is to dispel a common myth - that the Saudis are waging a war on US shale producers. No - the Saudis are waging a war on everyone. Every oil producer is their target and their reasoning is based on fundamental economics. Geopolitics and conspiracy theories aside, investors should see this current situation for what it is - an attempt by a large producer to bring order to a broken market. To those who claim that the Saudis are not maximizing revenue by selling fewer barrels at a higher price, I say that they are indeed maximizing revenue - just over a longer term than most market participants function in. The Saudis understand both the coming 'decarbonification' of the global economy, and the increasing role played by other sources of energy such as renewables and natural gas. Rather than let their low cost oil become a stranded resource they are trying to sell as much as they can - this is entirely compatible with a long run revenue maximization strategy. In addition, the Saudis want to re-establish an effective cartel, possibly with Russia as well. The only way to do this and to ensure that members learn from past indiscretions is through this 'shock and awe' strategy. Barring a major war or a random act of nature, the price of oil will continue to slide to where the Saudis want it to go. This is probably under $20BBL, possibly close to $15BBL. The carnage in the energy sector will be a once in a generation event which will shape industry participants for years to come.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.