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What Is Saudi Thinking?

My Enemy's Enemy is My Friend

Watching the mainstream media repeating statements in the absence of in-depth knowledge, understanding, or critical analysis, you would think that Saudi Arabia and the rest of OPEC has just openly declared war on unconventional oil producers in the United States. Given the fact that the explosion in spending and capital deployment of unconventional producers in the United States has almost single-handedly kept our economy in the black since the financial meltdown of 2008, this declaration of war would not simply be on the producers, but on the United States economy as a whole. Wait, you say, lower oil prices act as a huge tax break on American consumers. Right you are, and consumers are immediate beneficiaries of the cascading oil prices, just in time for Christmas, however given that strength in employment and housing statistics these last number of years can all be traced back to strength in energy capital spending this is a dangerous game of robbing Peter to pay Paul. Short term boost and medium term collapse. Also, would it make sense for Saudi to economically go to war with arguably their biggest ally and inarguably the biggest pool of demand pull for their only commodity and the basis of their entire economic and political system? Additionally, Saudi Arabia has openly commented on the fact that they are willing and able to withstand low oil prices for up to a year. If you flip that around it means that they are only able to withstand low oil prices for a year, a much shorter duration than the vast majority of shale producers in the United States, many of whom are well hedged for the next year and have capital spending flexibility. So this begs the question, where do Saudi and the rest of OPEC and large non-OPEC nations fall out on the cost curve, when you bake in the governmental budgetary burden, relative to United States shale plays? All of these questions and inconsistencies in stated goals versus actual impacts begs the bigger and more important questions - what are Saudi's real goals and what are the investment implications for an United States independent energy investment landscape that suddenly finds itself in some cases in a going out of business sale?

An Unequivocal Fact

It cannot be overstated, the United States economy has remained above water and barely showing growth the last number of years since the financial crisis primarily because of the energy renaissance that has been going on in this country. The positive impact of a large ramp in capital spending into shale development has invigorated the employment statistics, needing to look no further than shale state unemployment rates relative to non-shale state unemployment rates, with states like North Dakota boasting a 2.8% unemployment rate, Colorado 4.3%, Montana 4.5%, Texas at 5.1%, Ohio at 5.3%, and Pennsylvania at 5.4% v. the overall United States at 5.8%. Whatever the economic statistic you look into, the states where shale drilling is prevalent are doing better. Additionally, producing a higher percentage of our energy demand, reduces imports, strengthens the dollar, improves tax revenues, the budget deficit, and our balance of trade. This also improves our global political clout by making us less dependent on the Middle East, more able to pursue appropriate political policy vis a vis Russia, and strengthens the view of the dollar and our governmental debt. Finally, producing more energy internally effectively puts a longer term cap on energy prices, taking that power away from OPEC, and puts the United States in a more globally competitive position in regard to the stability and lower level of power prices in this country, also helped by natural gas in this regard, but that is another day's topic.

Industry by Industry

Rails, Truck, and Barge companies have benefited from oil transportation volumes due to pipeline constraints and have also benefited from fracking material transportation volumes. Rail & Truck manufacturers have benefited from huge demand for tanker cars. Rental equipment companies have benefited from the myriad equipment used on site for preparation and development of drilling sites. Construction companies have benefited from transportation infrastructure build out to support growing processing and volume movements. Financial services industry has benefited from record debt and equity issuance to support all the capital projects either directly related to or in some way derived from the energy build out. Manufacturers have benefited from closer, more reliable, and lower power prices versus other areas of the world. The government (unfortunately the biggest industry in our country - again another day's topic) has benefited from increased regulation creating jobs and increased fees and taxes to support our ballooning spending. Industrial, construction, and oil service equipment manufacturers have benefited from the higher demand, higher rates, and more equipment turnover and servicing. Housing and Autos have benefited from an improvement in the employment situation in many areas supported by shale drilling. I will stop there, but hopefully you get the idea, if you dig deep enough (pun intended) energy is at the bottom of a lot of strength in our economy for the last number of years.

Saudi is Rational and Practical

They share the same goals as US producers - oil prices high enough over the long term to earn a return, support their constituents, and stay in power, while not so high as to hurt demand and economic growth. The fact that they would be at war with the biggest consumer that buys their commodity is ludicrous and doesn't pass the smell test for a regime that is notorious for rationality and practicality. Additionally, if we examine the statement recently by Saudi Oil Minister Ali al-Maimi that the kingdom can weather lower oil prices for a year, it is more a statement of weakness than of strength. As any highly leveraged company knows, you don't wait until your debt comes due to refinance, therefore it is unlikely Saudi is truly willing and able to standby and do nothing for a year before making a move to support prices. The Saudi governmental budget and spending plans requires pricing of around $100 longer term. They, and all the OPEC nations, have gotten fat on high prices these last number of years and built that into their governmental and social program spending. As we all know, once government expands, it rarely ever shrinks again unless faced with survival and the willingness to weather a period of difficult austerity to reign it in and reinvigorate private sector growth. Therefore, it is easy to conclude that whatever Saudi's near term goal is, their long term goal is definitely sustainably higher oil prices than we have today.

Where are U.S. Shale plays on the cost curve compared to OPEC and Non-OPEC Producers?

To examine this it is critical to note that in assessing country level cost curves, we are baking in governmental spending and budgets into their cost to produce whereas private enterprise in the United States bakes has no such burden above the tax and royalty rates built into their business models. While estimates vary by analyst on each country or play's economic break even I have chosen more conservative shale assumptions and the most generous country assumptions to prove the point that even with this methodology, shale basins in the United States are more cost competitive than governmentally burdened country level production. Here is a sampling of oil price thresholds generally held to be needed for OPEC national budgets to be balanced..Libya $184, Iran $131, Algeria $131, Nigeria $123, Venezuela $118, Saudi Arabia $104, Iraq $101, UAE $81, Kuwait $78, Qatar $77.

For non-OPEC Russia which garners roughly half of its revenues from the oil and gas industry, the budget though 2017 has been based on roughly $100 oil. There is good reason the Ruble has been tumbling since the OPEC no-cut decision.

One caveat that I would like to stress before moving on to the U.S. shale economics. Government budgets, like corporate capital spending can be flexed. It is quite possible that these numbers could be massaged down considerably, perhaps 25% or even 50% in some cases, but it would not be without significant pain, and it would not be by choice over a long period of time, rather it would be out of necessity due to a poor global economic backdrop. A long term war of attrition via widespread government austerity in some of the least stable countries in the world is not a palatable choice for these governments in my opinion.

Now examining U.S. oil shale break-even estimates, here is a sampling, ranges given depending on the area and horizon within the play - Eagle Ford $50-75, Permian $60-100, Wattenberg $55, Bakken $70-80. Even the emerging Tuscaloosa Marine Shale rings in at $75-80 and should move meaningfully lower with development stage costs.

Hmmm. Combining these two datasets paints a very interesting picture. It also begs the question of why you would go to war with someone you cannot out-last, out-maneuver, or out-gun? The answer - you wouldn't! Granted, if in taking down prices for a period of time you injected a modicum of caution into U.S. producer annual capital spending budgets and made access to capital that much more difficult for a period of time that might be a nice side benefit, but it can't be the reason. It is clear that, barring a prolonged U-turn toward austerity for OPEC nations and Russia, or significant periods of dramatic deficit spending which would undermine their currencies, U.S. shale is going to be developed and is going to be a share gainer long term. Especially when you consider the fact that technological innovation and best practices continue to march the cost curve lower for many of these unconventional plays. Saudi realizes this too, and they realize then that the only way for them to win longer term is to preserve as much share as possible, retain their pre-eminent position as the leader of a strong OPEC, stimulate as much demand as possible, and create a backdrop where prices average at least $90 a barrel longer term.

The Best Hiding Place is Often in Plain Sight

So what U.S. shale production becomes for Saudi Arabia is the perfect cover story. They can create OPEC solidarity by openly claiming their enemy as United States private enterprise - what better rallying cry than that among nations that largely dislike us. This enables them to carry out the rest of their agenda in plain sight, some of what agenda they share closely with the United States government. They put tremendous pressure on Russia, Iran, and Venezuela whose budgets and dependence on oil arguably outweigh even Saudi's and do so right at a time when they fear the rising power and unpredictability of Putin and ISIS. They rally the OPEC nations closer together to keep solidarity and control. They stimulate demand globally at a time when the global economy could really use the relief and stimulus. They strengthen relations behind the scenes with the United States. And ultimately, when they finally do cut production to firm up pricing, they not only get to play the part of hero, but they have terrified the rest of OPEC into sharing in the market share yielding longer term that they know is inevitable so that they don't have to absorb it all themselves.

The Fat Pitch

What does all of this mean for US equity investors and most specifically for long term investors? While the vast majority of market participants are focused on the spot price of oil and where they are going to mark their funds to market come the end of the year to collect their bonuses, they have been vomiting anything energy related and extrapolating that the current oil price environment is the new long term paradigm. Indeed, if we believed that $60-70 oil was the "new normal" for the next five years we wouldn't want to own many oil related companies either. In fact, it wouldn't stop at energy, it would extend to all those industries whose growth, returns, and valuation have been supported by the strong cycle in oil shale development over the last number of years. We however don't believe that, and are willing to look through this dislocation to a period of sustained higher oil prices in the $90 range over the medium term 2-5 year outlook. We have knowledge, discipline, patience, time horizon, and most importantly right now attractive valuation 'fat pitch' on our side. Over the next few months of uncertainty and chaos in the oil markets you will do well to sharpen pencils and identify those companies you believe can weather the short term and thrive in the long term. To quote Rudyard Kipling, "If you can keep your head when all about you are losing theirs..."