There has been much written about the recent collapse in oil prices and what the possible motivations are. Saudi Arabia, OPEC's historical swing producer, says "don't panic - we are just protecting our market share, the market will adjust." Adjust it will. But what exactly are the market share dynamics for Saudi Arabia and what will it cost the Kingdom to learn the threshold of pain for US shale producers?
According to OPEC's November report, and as most of you already know, the vast majority of non-OPEC yoy production growth over the past three years has come from the OECD Americas:
In particular, the US has accounted for an increase of ~1.4 million bpd yoy of total non-OPEC supply growth of ~1.6 million bpd, or about 82% of non-OPEC production growth.
Meantime, world oil demand is expected to average 91.19 million bpd, a yoy increase of 1.0 million bpd (see chart below).
So we've got non-OPEC growth (mainly from the US) of ~1.6 million bpd, and worldwide demand growth of ~1 million bpd. With OPEC holding production relatively flat, that means there is an extra 600,000 bpd of oil hitting the market. On a CNBC interview Thursday morning, Exxon Mobil (NYSE:XOM) CEO Rex Tillerson summed up the ~600,000 bpd supply surplus and resulting price correction perfectly:
So you fill up storage, you fill up your inventories, and at some point it has got to show up in the price.
So it is the 600,000 bpd supply/demand imbalance that is causing all the chaos in the oil markets - a mere 0.7% of total global oil demand. In a previous Seeking Alpha article (How Libya Sunk The Oil Frackers' Stocks), I described how this is just about the same amount that Libya took offline (with Saudi picking up the slack) and then brought back online (with Saudi not willing to cut-back).
Referring once again to the latest OPEC monthly report (see below), we see that Saudi Arabia is currently producing ~9.6 million bpd. That equates to 32% of total OPEC production and 10.5% of total global demand.
Saudi Arabia has a population of ~29 million - only 0.4% of the total global population of ~7.125 billion. So let's see, the country has 10.5% of global oil production and only 0.4% of the world's population. In contrast, Iran has more than 2.5x more citizens (77.5 million) than does Saudi Arabia yet is only producing 2.7 million bpd, which equates to only about 3% of global oil demand - less than 1/3 of Saudi Arabia's market share. It appears to me that if any country should be concerned about market share - it's Iran, not Saudi Arabia. A similar argument could be made by Iraq. Greed may be good, but there is often a price to be paid.
Cost of Defending Market Share
It's clear Saudi Arabia doesn't want to cut its production by the 600,000 bpd needed to balance supply with demand. In particular, it would appear the Kingdom wants to find out how strong the new kid on the block is (i.e. US shale oil producers). So what will it cost Saudi Arabia to make its point and get the information it desires?
First off, the EIA reports that Saudi Arabia has 16% of the world's total proven reserves (as of year-end 2013) and is the largest exporter of total petroleum liquids in the world. It is also the largest consumer in the Middle East at about 3 million bpd. That means the country is currently exporting about 6.6 million bpd. So, let's tally the export revenue numbers as a function of Saudi Arabia's 6.6 million bpd of exports at today's Brent close of $70/bbl, and at $60/bbl, versus 6 million bpd (i.e. a cut of 600,000 bpd to balance supply/demand) at a probable price of $100/bbl.
Saudi Arabia Oil Export Revenues
|6.0 million bpd||6.6 million bpd|
It is easy to see that the extra 600,000 bpd of production which would otherwise bring supply and demand into balance is currently costing Saudi Arabia ~$138 million/day, or ~$50 billion/year.
So the Saudis are content to produce more oil for less revenue simply to maintain a "market share" that one could argue is already way to high in comparison to the country's population and with respect to other producer nations - namely, the US and Russia (reserves aside).
Saudi Arabia reportedly has the 3rd largest foreign exchange reserves as measured in US dollars:
I must admit I don't really understand Wiki's foreign exchange reserves list because it has the US as #19 with $135 billion of reserves (last I knew, the US was up to its eyeballs it debt). Regardless, the point is that Saudi Arabia, after decades of exporting oil, has built up a $745 billion in foreign reserves.
Saudi Arabia has an annual budget of ~$228 billion, which is expected to be, roughly, balanced this year despite the precipitous recent drop in oil prices. Next year, if the budget were to stay the same, and oil were to average $70/bbl, the estimate above of $50 billion less in oil revenues implies a deficit of $50 billion for the year. At that rate, Saudi Arabia could withstand $70/bbl oil for ~15 years before running out of US dollar denominated foreign reserves. No sweat.
But What Will It Accomplish?
It appears to me Saudi Arabia is willing to spend a very large sum of money simply to find out what the threshold of pain is (in $/bbl) for US shale producer. That is, at what price point will US shale production stop growing?
Honestly, I don't think anyone knows at this point. The reason is US shale oil production isn't dominated by a single company. While companies like EOG Resources (NYSE:EOG), Continental Resources (NYSE:CLR), and ConocoPhillips (NYSE:COP) have significant operations in the Eagle Ford, Bakken, and Permian Basin, there are a large number of smaller companies that have production in these and other plays - like the Niobrara, and multiple liquids-rich plays in Oklahoma. All these companies are looking at each other to see who will blink first. They will all likely blink some. It's a complicated patchwork to analyze.
And we have already seen a big change in new drilling permits - down nearly 40% in November as compared with October. While this is a leading indicator (perhaps 60 days out), the drop from 7,227 new well permit approvals in October to 4,520 in November is stunning. Drops were seen across the board:
Change In Drilling Permit Approvals Nov./Oct.
This is about what we would expect. Despite the media hoopla about the Permian, there are some quite marginal regions within the play so it is no surprise it saw the biggest drop in permits. After all, this is why the bigger companies mentioned earlier concentrated on the most economic shale plays first: the Eagle Ford and the Bakken and were careful to finish preliminary engineering work before embarking on full-on "manufacturing mode" in the Permian.
With the rapid production decline rates of Hz frack'd wells, and with new well permits down ~40%, we should see a significant pull-back in US production - likely within about 3 months. In the long run, as new geologic and cost information feeds the logistics models of all the major shale oil producers, I think Saudi Arabia might be surprised at how elastic US shale oil production will be in the coming years. That is - how fast US shale producers will be able to adjust supply as a function of price.
However, there is another variable in the equation that will affect production on the margin, but is nevertheless material to the overall conversation: oil services, drilling and completion costs. As the number of new wells shrinks, oil service providers are going to have to compete for business. As a result, drilling and completions costs are poised to drop significantly. This is confirmed by the ~33% fall in oil service stocks over the last 6 months as measured by the Market Vectors Oil Services ETF (NYSEARCA:OIH):
As a result, the calculus of determining what shale well is "marginal" will change by the second order effect of reduced drilling and completions costs. A Bakken well that had a D&C cost of $10 million in July might end up with a D&C cost of $9.5 million, or perhaps even $9 million. This would obviously have a direct impact on IRRs as a $500,000 reduction in breakeven cost equates to an EUR delta of 8,300 barrels at $60/bbl. On a Hz well with a fast decline rate, that pulls in the breakeven point by several weeks. In addition, producers may have lower expectations for returns going forward due to the new reality of lower prices. What may have been an unacceptable IRR at $100/bbl oil, may now be acceptable at $70 (or even $60) oil. So it is going to take some time for all this to settle out - I would suspect 6-9 months at least, but who really knows?
Meantime, lower oil prices should boost global oil demand. Lower gasoline prices should lead to an increase in growth in the world's two leading economies and two largest oil consumers: the US and China.
Throw in global political and security wild cards, and anyone who says they know how it will turn out is simply fooling their self. The new world order in oil supply/demand is obviously very complex. The biggest worry might be Russia - whose currency is collapsing and whose leader is very unpredictable (to put it mildly).
Summary & Conclusion
Saudi Arabia is paying a steep price to maintain what it believes is its share of the global oil market. Apparently it is worth $138 million a day for however long it takes to see what the threshold of pain is for US shale oil producers. They might be surprised at how long it takes to find out. In the long run, they may also be surprised to find out how elastic US shale oil production can be due to how quickly production can be raised and lowered as a function of price.
Meantime, lower oil prices will obviously be a stress-test for US shale producers and oil service companies. The most highly levered oil producers will be shaken out. At the same time, as oil service and D&C costs decline, and as company's adjust their IRR expectations in light of the new world order in oil, what may have been a marginal well back in July may become economically feasible in early 2015.
This much I think I do know: one beneficiary of lower oil prices in the energy patch may well be the low-cost producers of natural gas. As D&C prices decline due to lower oil prices, the natural gas producers, who have seen the price of natural gas stay relatively flat, are going to see lower operating costs and higher profits. If you think about it, everything in the O&G services business burns diesel: trucks, rigs, pumps - they all run on diesel. Ok, well some producers are using natural gas pumps, but it is still mostly a diesel-driven industry. So the point is that lower oil services, drilling, and completions costs are going to be a tailwind for low cost natural gas producers like Cabot Oil & Gas (NYSE:COG) in the US, and Peyto Exploration (OTCPK:PEYUF) in Canada. Peyto in particular has been irrationally sold-off in the face of an excellent Q3 EPS report: production was up 33%, EPS was up 114%, and the company boosted the dividend by 10%. Q4 looks great. For 2015 - lower services and drilling costs will likely see the low-cost natural gas producer in Canada reduce costs even further.
Disclosure: The author is long XOM, COG, COP, PEYUF.
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