Saudi Arabia To Flood The Oil Market In 2016?

| About: The United (USO)
This article is now exclusive for PRO subscribers.

Summary

Headlines around Saudi Arabia are misleading.

Saudi Arabia does not want oil left in the ground unsold.

Most casual observers are wrong about why Saudi Arabia plans to increase output.

Introduction

The primary reason I love Seeking Alpha as a platform is that it allows the truth to get in the way of a good story. Last Monday the oil news headlines were dominated with stories about Saudi Arabia increasing production. Discussions around Saudi Arabia being scared about the end of oil have resurfaced as well as their desire to destroy U.S. shale. While there are slivers of truth to all this, the real story is much more simple, obvious, and boring.

Ignore the hype

Modern news has become about generating clicks. Clicks are like ratings and generate money through advertising. This is not a bad thing per se; most of us on this site are capitalists and understand that news is a business like any other and needs to make a profit. However the desire for clicks like the desire for ratings encourages misleading headlines. If you couple that with our increasingly short attention spans you can see how many people quickly become uninformed on a topic. For investors in oil ETFs like the United States Oil Fund (NYSEARCA:USO) this can mean selling pressure as uninformed traders read the headlines, sell and ask questions later. Luckily you are reading Seeking Alpha and not one of those other sites.

For those that read beyond the headlines in last weeks news about the Kingdom of Saudi Arabia (KSA) increasing production, you would have seen three key points that were being made:

  • KSA needs to increase production to meet internal summer demand
  • KSA is looking to acquire production overseas to increase revenue
  • KSA needs to add some production to offset existing field decline

Note: For simplicity I use KSA and Saudi Aramco interchangeably in this article.

Saudi Arabia's plans

While I'll be the first to tell you to not believe anything that is said by an oil producer publicly, there are some things that Saudi Arabia has said that I believe to be true:

  • They don't want billions of barrels of their oil to remain in the ground when oil demand drops off some time in the future
  • Market share is very important
  • Share will be taken from high-cost producers
  • KSA does not intend to flood the oil market

I don't believe that KSA:

  • Is happy with the current price of oil
  • Can survive for a long, long time with the current prices
  • Will pump at any cost to destroy their enemies
  • Can transition their economy away from oil as fast as they say

The real motives of Saudi Arabia

Often the solution to a complex problem is simple and obvious, but people are too busy looking for a complex answer that they miss it.

Here it is:

Saudi Arabia does not want market share to go to high cost producers.

To understand why this is so simple, you need to understand that the price of oil should match the cost of the marginal barrel in a balanced market. The marginal barrel is the cost to produce just one more barrel than the current total being produced.

Source:Nasdaq.com

In 2012 (and earlier), the marginal cost was very high for a number of reasons but mainly that world demand was not being met by supply. Because the price was so high it made sense to look for oil deep under the sea or in places with little oil infrastructure like North Dakota (the Bakken specifically). Saudi Arabia likely never thought that the U.S. could produce so much oil and made a strategic error by leaving the price high for so long without adding production. It wasn't as simple as I make it sound as the oil markets are complex, but my key premise is that they and other OPEC nations are not looking to repeat this mistake.

Saudi Arabia wants to be the one providing those high-margin barrels in the future when the price goes higher.

Many have made the mistake of assuming that Saudi Arabia wants to keep oil at $30 or $40. This is not the case as this price is certain economic death for them. Saudi Arabia just wants to avoid oil going so high that we see another Bakken happen somewhere in the world. It's just that simple.

Conclusion

Saudi Arabia is not trying to keep the price of oil down by flooding the market in a bloody war of market share. All the talk about Saudi Arabia not wanting to keep barrels in the ground relates to the fact that if there is good money to be made in oil, Saudi Arabia has the fattest margins and want those future sales. They do not want to see other countries experiment with shale, nor do they want the supermajors drilling in the Arctic for something they can supply at a much greater profit margin.

It's simply not an interesting story, but I believe it to be the truth.

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.