One of the more interesting parts of the ongoing oil narrative is how relatively quiet Saudi Arabia has been over the last couple of months. It has occasionally spoken about steps it'll take going forward in the new oil environment, but in general, as far as related to more controversial elements of the market, it has remained quiet. I'm specifically referring to whether or not it will agree to a production freeze, and how it has consistently stated it wants the market to rebalance on its own.
That quiet has been shattered by Fitch on Tuesday after the ratings agency downgraded Saudi Arabia from AA to AA-. It had already been downgraded by Standard's and Poor's earlier in 2016.
Even though oil has been under pressure for a couple of years, the Saudis have continued to ramp up production. Since January 2011 it has tripled the number of rigs in use. That suggests it is preparing for the inevitable rebound in demand going forward, even with the rise of the U.S. shale industry. This will have an impact on the global market in the short and long term, with there being winners and losers even with demand rising over time.
The consensus is oil demand will rise to about 100 million barrels per day by 2020, with Saudi Arabia taking on some of that added supply in order to maintain its market share.
I'm not convinced of the 2020 time frame because I believe there will be a recession between now and then, which could easily drop the pace of demand for oil. That said, eventually it will get to that level, and Saudi Arabia, because of its aggressive investments, is positioned to meet the growing demand whenever it arrives.
While that's true, the Saudis are preparing for a prolonged period of time when the price of oil is lower than in the past. The country won't have the number of benefits past revenue allowed it to enjoy, being forced to make many significant budgetary adjustments and abandon numerous projects it had in the pipeline, along with non-essential projects that were already in place. It has also reduced some subsidies and raised taxes.
Fitch's outlook for oil prices
In the midst of all the hoopla about the upcoming meeting in DOHA where discussions about a production freeze have pushed the price of oil up, Fitch maintains a much more subdued outlook, with an average price of $35 per barrel projected for 2016 and $45 per barrel for 2017. This is much more in line with actual fundamentals than those making projections of oil jumping to as high as $80 per barrel by the end of 2016.
I'm more in line with Fitch than those riding the momentum and enthusiasm surrounding an expected production freeze, because many still ignore or don't understand a stronger oil price will bring many more U.S. producers back to the market, and it will generate a lot more supply, which will offset any temporary price support generated from a production freeze, if it in fact does become a reality.
If for some reason there is a freeze and the market responds positively to it by pushing up oil, it will only extend the period of time it will take for the market to clear itself of weaker players. Saudi Arabia knows this, which is why it hasn't been supportive of a freeze, preferring a market solution. Either way, it will be the market that determines the price of oil over time.
Saudi Arabian investment and rigs
Having followed the oil industry for some time, including comments from OPEC members through the years, I'm convinced that outside the U.S., Saudi Arabia is best at understanding the ongoing changes that will have an impact on the future of oil - now and in the years ahead.
It knew demand for oil would continue to grow and because it has a low cost basis of approximately $10 per barrel, it has taken some of that excess revenue and continued to invest it over the last several years.
In January 2011 it had 23 rigs in production, while in March 2016 it had 69 rigs. It plans on continuing to spend on upstream projects in preparation for the increasing demand for oil, no matter how long it takes to get to 100 million barrels per day or higher. This is why, even though it has to adjust domestically to declining revenue, it can patiently wait for that time to come.
That doesn't mean it won't face challenges, as it went through almost $100 billion of reserves in 2015. It also has gone to the bond market to raise revenue. Saudi Arabia will do fine for at least a couple of years, but it obviously can burn through capital at the rate it did in 2015 without some serious consequences. Part of the consequence is the increased cost of capital as a result of a weaker credit rating.
What Saudi Arabia needs to do to maintain market share
Over the last 20 years or so, Saudi Arabia has held a global oil market share of 12 percent to 13 percent. It retains that under current market conditions by supplying the market with a little over 10 million barrels of oil per day. It has an additional capacity of 2.5 million barrels per day.
In the past it could use the extra capacity to balance the market when it went out of balance, but since that will no longer work because of the emergence of the powerful U.S. shale industry, it has chosen to sit on that; presumably in anticipation of the market rebalancing itself.
By that I'm not suggesting the Saudis will work at full capacity, but that they have a lot more room to boost supply when it's more profitable for them to do so. It'll still have the ability to supply more than it does to the market, but it'll be added on top of whatever supply level it eventually jumps to as demand for oil climbs higher over the next several years.
Assuming Saudi Arabia will work to keep its market share at past levels, it would mean boosting production to about 15 million barrels per day based upon demand growing to 100 billion barrels per day. That should include at least 2 million barrels per day idled for emergency situations. In my view supplying about 15 million barrels per day is the target investors should be looking for concerning Saudi Arabia when demand closes in on 100 million barrels per day.
When taking into account Saudi Arabia and the projected price of oil over the next couple of years from Fitch, the outcome, while not guaranteed, is likely to mean more pain for a lot of oil producers around the world, including Saudi Arabia.
The reason there are such wide disparities between the price of oil is one side is looking at the fundamentals, while the other side is looking for artificial props like a production freeze to support the price of oil, even if the market doesn't reflect that as a reality.
Why I'm on the bearish side of the price outlook is because of the nature of U.S. shale production itself, which can be held off until the price of oil strengthens. The stronger shale producers are looking from $40 to $45 per barrel as the trigger point for starting production at their drilled but uncompleted wells. If that happens, it'll completely remove the reason for propping up oil, as it'll allow even some of the failing shale producers a chance at minimum, of extending the life of the company, and at best, could not only save the companies, but end up with them being long-term global competitors.
For that reason, Saudi Arabia has pushed for the market to decide the winners and losers. The problem for the Saudis is it still being a part of OPEC, where poorly run national companies can't come close to competing with their peers. But in order to at least give the semblance of unity and internal support, the Saudis have been for the most part quiet as OPEC members push for a production freeze.
Again, what they refuse to see is this will result in their streamlined competitors rising up and further eroding market share. That's the cycle the oil sector faces since shale producers in the U.S. grew into fierce competitors. It's why the market should be left alone, as the Saudis have rightly stated.
This is why a production freeze, if it happens at all, is counterproductive. Sure, it'll give a temporary boost to the price of oil, but if it jumps too high, there are literally 5,000 or so DUC wells in the U.S. waiting to be brought into production at the opportune time. When and if that happens, the weak OPEC and non-OPEC members will quickly find out it was a mistake to attempt to support oil in the same way it was done in the past.
Those investors with positions in oil producers with significant exposure to shale will enjoy some good profits.
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.