Shale Oil

Short-term crude forecasts are, well, crude forecasts

oilVivek Kaul

“The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith

In response to yesterday’s column a journalist friend asked “where do you see the price of crude oil heading in the days to come?”. A perfectly innocent question which does not have an easy answer.
First and foremost it is important to understand why the price of crude oil has fallen in the recent past. One explanation lies in the fact that the demand for oil has not risen at the same pace as it had in the past.
As Satyajit Das author of Extreme Money writes in a recent research note titled Reverse Oil Shock: “ Weak demand contributes perhaps 30-40 percent of the fall. In 2014, oil demand grew by around 500,000 barrels per day, below the 1.3 million barrels growth projected earlier, reflecting weak economic activity in Europe, Japan and emerging markets, especially China.”
At the same time this slow increase in demand has been met with an increase in the supply of oil. With high oil prices, other sources of oil like shale oil in the United States and oil from tar sands of Canada, have also become viable. As Das points out: “Increased supply contributes 60-70 percent of the decline. In a pattern reminiscent of earlier price cycles, several years of high prices and strong demand has encouraged new sources of oil supply to be brought on stream, causing the price to adjust.”
The production of US shale oil has gone up by 4 million barrels per day since 2008. This has led to a situation where the United States produces 9 million barrels per day of crude oil, only around a million barrels lower than Saudi Arabia.
Also, oil from other traditional oil producing countries like Libya has also hit the market in the recent past. Libyan oil production increased by around 800,000 barrels per day after the “reopening export terminals following a truce agreed between tribal militias in the civil war”.
To add to all this has been the decision of the Saudi Arabia led Organization of the Petroleum Exporting Countries (OPEC) not to cut production with the fall in oil prices, as it has done in the past. It needs to be pointed out that Saudi Arabia has been a swing oil producer in the past, where it has either increased or decreased its production to ensure that global supply of crude oil equals its demand.
But that hasn’t happened this time around as Saudi Arabia hasn’t cut production. Why is that the case? On the previous occasions Saudi Arabia cut production it ensured that crude oil prices continued to remain high and in turn, benefited other countries.
As Das writes: “In the mid-1980s, Saudi Arabia cut its output by close to 75 percent to support weak prices. The Saudis suffered a loss of revenues and also market share. Other OPEC members and non-OPEC producers benefited from higher prices. In recent years, Saudi Arabia has regained market share, benefiting from the disruption to suppliers such as Iran, Iraq and Libya.” And given this, the Saudis are not in the mood to hand over their market share to other countries.
Hence, they would rather hold on to their market share than cut production and sustain a higher crude oil price. Also, shale oil is expensive to produce and by driving down the oil price Saudi Arabia is trying to make the entire shale oil business unviable.
As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.”
Brent crude oil is currently quoting at around $50 per barrel. If crude oil continues to sell at $50 per barrel or lower, it is for sure that US shale oil producers will go bankrupt in the days to come. As Jensen puts it: “OPEC (with Saudi Arabia in the driving seat) may exhaust itself and decide that enough is enough, or it may go for broke – in this case it would want U.S. shale producers to go bankrupt and exit the industry forever which, we note, is quite likely to happen, should the oil price stay at current levels or lower for any extended period of time.”
The trouble here is that this assumes that the United States will sit back and do nothing. But as history has shown the politics of oil is never so straightforward. As I had pointed out in yesterday’s column the shale oil companies have been major job creators in the United States.
As analyst Jawad Mian points out in the Stray Reflections newsletter for January 2015: “It is undeniable that the oil and gas sector has become a key driver of US economic activity…It has been responsible for about 30% of the 10 million national increase in jobs since the global financial crisis.” Oil companies have been major job creators in the states of Alaska, Texas, Pennsylvania, North Dakota, Colorado, West Virginia, Wyoming, Oklahoma and Montana.
Given this, chances are that the US political establishment will not sit back and watch if shale oil firms start shutting down. “It is now a highly political chess game and, as I have learned over the years, when politics enter the frame, logic goes out the window,” writes Jensen.
At the same time the shale oil firms are politically very well connected in the United States. This can be made out from the way the shale oil firms are allowed to operate. As Jeremy Grantham writes in the GMO Quarterly Newletter for the third quarter of 2014: “There are few if any constraints, for example, on what chemicals and in what amounts, can be pumped into a fracking well. Nor is the leakage of methane (natural gas) from the drilling and pipeline operations seriously monitored despite the fact that methane is over 86 times as potent a greenhouse gas, at a 20-year horizon, as CO2 is.”
This demonstrates the “the remarkable influence of the energy industry over the U.S. governmental process, if “process” is not too dignified a word,” writes Grantham. Grantham is one of the most well respected fund managers in the United States. And given what he says, the shale oil companies must already be working the United States government to do something about Saudi Arabia driving down the price of crude oil.
At the same time the US benefits from low oil price as well. “A number of U.S.-antagonistic countries around the world (think countries like Russia, Iran and Venezuela) will be seriously weakened as a result of lower oil prices, which will strengthen the position of the U.S. in global politics,” writes Jensen.
Low oil price also benefits the US consumers given that they have more money in their pocket to spend on other things. As Das explains: “Lower oil prices increase disposable income. The average US motorist spends around US$3,000 per annum on gasoline. US households may save around US$500 to US$600 a year. If this money is spent then it will boost growth. There are also indirect channels such as transport costs. It also affects agriculture, which is four to five times as energy intensive as manufacturing.”
Given this, it will be interesting to see how the US political establishment reacts to a fall in crude oil prices and that will to some extent determine where oil prices head in 2015, even though it seems that they will continue to remain low in the short term.
Further it is worth remembering that the price elasticity of crude oil is low especially in the short run. This means even a small disruption in supply can lead to oil price shooting up rapidly. As Das puts it: “The structure of the oil market entails fine margins between demand and supply. The current oversupply is around 2 million barrels a day, less than 2 percent of global consumption…Key uncertainties include weather conditions, unanticipated supply disruptions and geo-political factors.”

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 13, 2015

Oil at $65: Where oil prices go will depend on who blinks first, shale oil producers or OPEC

oil

Vivek Kaul

The West Texas Intermediary (WTI) crude oil price has touched a five year low of $65 per barrel. As I write this, the WTI price stands at $64.5 per barrel. WTI is one of the grades of crude oil and is used as a benchmark to set oil prices.
This fall in oil prices has come about after the Organisation of the Petroleum Exporting Countries(OPEC) in a meeting on November 27, 2014, decided not to cut their production. In the past whenever oil prices fell, OPEC used to cut production in order to ensure that prices did not continue to fall. This has not happened this time around.
The primary reason for the same has been the rise of the shale oil producers in the United States. The United States was producing around 4 million barrels of oil per day in mid 2008. Since then the production has jumped to 8.97 million barrels per day (as of end of October 31, 2014). The entire incremental production has come from shale oil.
This has meant that the United States which is the biggest consumer of oil in the world is importing far lesser oil than it was in the past. Amrborse-Evans Pritchard writing in The Telegraph points out that “America has cut its net oil imports by 8.7m barrels per day since 2006, equal to the combined oil exports of Saudi Arabia and Nigeria.” This is a reason to worry for OPEC and it has decided to not cut production significantly, and in the process it hopes to make shale oil producers unviable.
Prtichard also quotes Chris Skrebowski, former editor of Petroleum Review, as saying that Saudi Arabia wants to cut down the annual increase in the production of US shale oil from the current one million barrels per day to 500,000 barrels per day. Saudi Arabia is the leader of the OPEC cartel and OPEC largely does what Saudi Arabia wants it to.
Given this it is not surprising that OPEC has continued to maintain a production of over 30 million barrels per day, despite falling oil prices. As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: “It is not surprising to see OPEC production – relative to its 30 million barrels a day quota – rising from virtual compliance to one where the cartel is producing above its agreed production allocation. Output rose to 30.974 million barrels per day in October, a 14-month high led by gains in Iraq, Saudi Arabia and Libya.”
The production of OPEC in the month of November 2014 stood at 30.56 million barrels per day. This was lower than the production in October, but still higher than the target of 30 million barrels per day.
OPEC is working with the assumption that shale oil is expensive to produce Nevertheless as I pointed out in an earlier piece on shale oil there are as many estimates on the production cost of shale oil going around, as there are analysts.
In a September 2014 report Bank of America-Merrill Lynch had put the production costs of shale oil from $50-75 per barrel. Mian whose newsletter I have quoted earlier put the break-even price at $57 per barrel. Analysts at Citibank recently said that the price of oil would have to fall below $50 a barrel for completely halting shale oil production in the United States.
Evans-Pritchard goes even lower. As he writes: “The International Energy Agency said most of North Dakota’s vast Bakken field “remains profitable at or below $42 per barrel. The break-even price in McKenzie County, the most productive county in the state, is only $28 per barrel.” He quotes Edward Morse, Citigroup’s commodities chief as saying that the  “full cycle” cost for shale production is $70 to $80, but this includes the original land grab and infrastructure. Nevertheless, the remaining capital expenditure “to bring on an additional well, could be as low as the high-$30s range.”
A Bloomberg report points out “Only about 4% of US shale output needs $80 a barrel or more to be profitable, according to the International Energy Agency. Most production in the Bakken formation, one of the main drivers of shale oil output, remains commercially viable at or below $42, the Paris-based agency estimates.”
What these data points tell us is that the Saudi led OPEC will have to drive down oil prices further, in order to ensure that production of shale oil becomes unviable. At least that is the observation one can make from all the data that is available.
The question is till when OPEC keep driving down prices. Mian estimates that “the current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion”. Further, “lower the price of oil falls, the greater the need to compensate for lower revenues with higher production, which paradoxically pushes oil prices even lower,” Mian writes.
Most OPEC countries have built their budgets around high oil prices. “Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment,” writes Mian.
Hence, the oil price at which the budgets of OPEC countries and other oil exporting countries breaks even, is very high. “The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup,”writes Evans-Pritchard.
Given this, while the OPEC is trying to make shale oil unviable it is bleeding as well.
Nevertheless, Saudi Arabia seems to have decided that it wants to drive down the price of oil and that is what is important. The Kingdom has the ability to withstand lower oil prices for a few years, feels Mian. As he writes “Saudi Arabia appears to be comfortable with much lower oil prices for an extended period of time. The House of Saud is equipped with sufficient government assets to easily withstand three years at the current oil price by dipping into their $750 billion of net foreign assets.”
The question is who will blink first, the Saudi Arabia led OPEC or the shale oil companies. And that will decide how far the oil price will fall.

The article originally appeared on www.FirstBiz.com on Dec 2, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Saudi emerges king at OPEC meet: Oil prices will remain low for now

oilVivek Kaul

The oil ministers of the Organization of Petroleum Exporting (OPEC) countries met in Vienna yesterday. They decided to keep the total production of oil coming from OPEC at 30 million barrels per day. This is one million barrels per day more than OPEC’s estimate of the demand for its oil in 2015.
“It was a great decision,” said Saudi Oil Minister Ali al-Naimi, after talks which lasted for around five hours. With this decision not to cut production the price of oil fell further, and as I write this the price of Brent crude oil stands at $72.2 per barrel of oil.
The decision not to cut production went against the demand of OPEC members like Iran and Venezuela, who had demanded that production be cut. A falling oil price is hurting these countries badly given that money earned from selling oil is a major source of revenue for the respective governments.
Also, in the past, OPEC has been quick to cut production whenever prices have fallen and that has ensured that prices don’t fall any further. But that doesn’t seem to be happening this time around. Saudi Arabia, the largest producer of oil within OPEC, wants to drive down the price of oil.
The question that crops up here is why did OPEC go with what Saudi Arabia wanted it to? It has 11 other countries as members as well. While OPEC has been regularly referred to as a cartel, it is important to understand that the structure of OPEC is different from that of a cartel. It is probably better to define the structure of OPEC as what economists call a “leading firm” model of oligopoly, a market which is dominated by a small number of sellers and in which the largest producer sets the price and the others follow.
Saudi Arabia is the largest producer within OPEC. Within OPEC, it also has the almost unquestioned support of what are known as the sheikhdom states of Bahrain, Kuwait, the United Arab Emirates, and Qatar.
These countries have faced threats from other OPEC members, like Iraq and Iran, in the past. For many years, Iraq had been eyeing Kuwait. It had tried to annex Kuwait in 1961 (and it tried again in the early 1990s). The support of Saudi Arabia, the largest nation in the region, is very important for these countries. Hence, these countries tend to go with Saudi Arabia, not leaving much space for the other member countries to disagree.
Moral of the story: OPEC does what Saudi Arabia wants it to do. And these days Saudi Arabia seems to want lower oil prices. Why is that the case? Look at the table that follows. The table shows the daily oil production in the United States, which had fallen to around 4 million barrels per day in 2008. It has since jumped up again to around 9 million barrels per day, the kind of level not since the mid 1980s.
This has happened primarily because of a boom in shale oil production in the United States. As Javed Mian writes in Stray Reflections newsletter for the month of November “The US pumped 8.97 million barrels a day by the end of October (the highest since 1985) thanks partly to increases in shale-oil output which accounts for 5 million barrels per day.”
The more shale oil United States produces the lesser it has to depend on OPEC and other parts of the world, to fulfil its massive oil requirements. The trouble is that shale oil is expensive to produce and is viable only if oil continues to sell at a certain price. Given this, Saudi Arabia wants to ensure that price of oil is driven down further, so that it can drive the shale oil producers out of business.
There are various estimates about the oil price at which it is viable to produce shale oil. A report brought out by Deutsche Bank said that around 40% of shale oil production in the United States next year, would be unviable if the price of oil fell below $80 per barrel. Very recently, this was a sentiment echoed by the chief economist of the International Energy Agency as well.
Nonetheless, Maria van der Hoeven, executive director of the International Energy Agency, contradicted her chief economist by telling Reuters recently that 82 percent of the American shale oil firms had a break-even price of $60 or lower.
There are still other estimates. As Mian writes in his newsletter “The median North American shale development needs an oil price of $57 to breakeven today, compared to $70 last year according to research firm IHS.”
Analysts at Citibank recently said that the price of oil would have to fall below $50 a barrel for completely halting shale oil production in the United States. Also, many shale oil companies would continue to remain viable for an oil price of anywhere between $40 to $60 a barrel. It would be safe to say that there are as many break-even prices for shale oil as there are analysts. And it is very difficult to figure out which of these estimates is correct.
This is not the first time Saudi Arabia is following the strategy of bleeding out its competitors. It did the same nearly three decades back. “This has happened once before. By the mid-1980’s, as oil output from Alaska’s North Slope and the North Sea came on line (combined production of around 5-6 million barrels a day), OPEC set off a price war to compete for market share. As a result, the price of oil sank from around $40 to just under $10 a barrel by 1986,” writes Mian.
Hence, Saudis are putting to work a strategy that they have used in the past. Nevertheless, it doesn’t seem to have had the necessary impact on the production of oil by shale oil firms in the United States. On November 10, earlier this month, the US Energy Information Administration said that the seven largest shale oil players would be producing 125,000 barrels per day more in December than they had in November.
One reason for this is that the money that has already gone into producing shale oil is essentially a sunk cost. Hence, production is not going to be stopped immediately. As Ben Hunt who writes the Epsilon Theory newsletter puts it “There’s just too much non-cartelized money, technology, and political capital invested in US shale production to slow it down.”
Also, companies already have long term production contracts in place. These contracts require that they deliver a minimum level of production, even if it means selling at a loss. “Failure to comply could mean the loss of the lease and any future upside when prices [are] normalized,” writes Chip Register on Forbes.com.
Legendary oil man, T Boone Pickens feels that Saudi Arabia has entered into a stand-off to “see how the shale boys are going to stand up to a cheaper price.”
To conclude, Saudi Arabia driving down the price of oil hasn’t yet had an impact on shale oil production. Given this, it is likely that Saudi Arabia led OPEC will continue to drive down the oil price in the months to come. “In the current cycle, though, prices will have to decline much further from current levels to curb new investment and discourage US production of shale oil,” writes Mian.
It is also possible that the United States government may decide to intervene and introduce “tariffs on cheap foreign oil imports,” to keep the local shale oil industry viable.
The United States government will also have to take into account the fact that Saudi Arabia buys and sells oil in dollars. This ensures that in order to earn these dollars countries carry out international trade in dollars and accumulate a major part of their foreign exchange in dollars. This ensures that dollar continues to have an “exorbitant privilege” allowing United States to repay its debt to foreigners by simply printing them.
Further, it also helps keep the interest rates in the United States low, as countries line up to invest their foreign exchange reserves in treasury bonds issued by the United States government. Given this, its a Catch 22 situation for the United States. Does it encourage its local shale oil industry and reduce its dependence on importing oil from the Middle East? Or does it work against the “exorbitant privilege” of the dollar? Its not an easy choice to make.
Hence, its safe to predict that oil prices will continue to be low in the short-term. There are too many interplaying factors at work making it impossible to predict how things will turn out to be in the long run.
All I can say is, stay tuned.

The column originally appeared on www.FirstBiz.com on Nov 28, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Eight things you need to know about falling oil prices

oil

Vivek Kaul

The price of oil has been falling for a while now. As I write this the brent crude oil is selling at around $80.4 per barrel. There are several reasons behind the fall and several repercussions from it as well. Let’s look at them one by one.

1) The Chinese demand for oil has not been growing at the same rate as it was in the past, as Chinese economic growth has been falling. As Ruchir Sharma, head of Emerging Markets and Global Macro at Morgan Stanley Investment Management wrote in a recent column in The Wall Street Journal “The growth rate in Chinese demand for oil has plummeted to nearly zero this year, down from 12% in 2010. This is arguably the main reason why oil prices are down.”
2) In the past when oil prices fell, the Organization of Petroleum Exporting Countries (OPEC) led by Saudi Arabia used to cut production to ensure that supply fell and that ensured that prices did not continue to fall. This hasn’t happened this time around. As the Saudi oil minister Ali Naimi told Reuters on November 12, “Saudi oil policy has been constant for the last few decades and it has not changed today.” He added that: “We do not seek to politicise oil…for us, it’s a question of supply and demand, it’s purely business.”
And what is this pure business Al Naimi is talking about? The United States and other western nations like Canada have had a boom in shale oil production. This boom has led to the United States and Canada producing much more oil than they were a few years back. Data from the U.S. Energy Information Administration shows that United States in 2013 produced 12.35 million barrels per day. This is a massive increase of 35% since 2009. In case of Canada the production has gone up by 22.8% to 4.07 million barrels per day between 2009 to 2013.
Shale oil is very expensive to produce and depending on which estimate one believes it is viable only if oil prices range between $50 and $75 per barrel. Hence, by ensuring low oil prices the Saudis want to squeeze out the shale oil producing companies in Canada and United States.
3) So is the Saudi policy working? The US Energy Information Administration in its latest Drilling Productivity Report said that the seven largest shale oil companies will produce 125,000 barrels more per day in December 2014 in comparison to November 2014.
Hence, the Saudi strategy of driving down oil prices to ensure that the production of oil by shale oil companies is no longer viable, hasn’t seemed to have had an impact yet. Nevertheless that doesn’t mean that a fall in oil prices will have no impact on shale oil production.
The International Energy Agency (IEA) has said that the investment in shale oil fields will fall by 10% next year, if oil prices continue to remain at $80 per barrel. Faith Bristol, chief economist of IEA recently said “there could be a 10 per cent decline in US light tight oil, or shale, investment in 2015 [from full-year 2014 levels]”…I wouldn’t be surprised to see statements from different companies in the weeks and months to come [outlining a change in] their investment plans and reducing budgets for investments in North America . . . especially the United States.” And this will have an impact on the production of shale oil in the medium term, if Saudis continue to sustain low oil prices.
4) Nonetheless, the interesting thing that the United States and other Western nations may never have to increase production of shale oil, just the threat of doing that will act as an insurance policy. As Niels C. Jensen writes in the Absolute Return Letter for November 2014 “There is nothing easier to get used to in this world than higher living standards, and the populations of most oil producing nations have seen plenty of that in recent years. Shale [oil] is a threat against those living standards, and falling oil prices are the best assurance they can hope for that shale [oil] will never become the major production factor that we are all being told that it could become. It is very expensive to produce and thus requires high oil and gas prices to be economical.”
But even with that shale oil can act as an insurance policy against high oil prices, feels Jensen. As he writes “In a rather bizarre way, shale [oil] has thus become an insurance policy, as the western world never have to ramp up shale production to levels that have been discussed. The sheer threat of doing so should keep the oil price at acceptable levels.”
5) Also, low oil prices are going to benefit nations which import oil. “A $20-per-barrel drop in oil prices transfers $6-700 billion from oil producing nations to consumers worldwide or nearly 1% of world GDP. Assuming consumers will spend about half of that on consumption, which historically has been a fair assumption, the positive effect on GDP in consumer countries is 0.5%,” writes Hunt. And this is clearly good news for oil importing nations like India. Falling oil prices are also benefiting airlines and shipping companies given that oil is their single biggest expense.
6) News reports suggest that China is using this opportunity to buy a lot of oil. As a recent report on Bloomberg points out “The number of supertankers sailing toward China’s ports matched a record on Oct. 17 and is still close to that level now.”
7) The countries that are likely to get into trouble if oil prices continue to remain low are primarily Russia and Iran. Russia relies heavily on exports of oil and gas. As a recent article on cnbc.com points out “In 2013, for example, Russia’s energy exports constituted more than two-thirds of total exports amounting to $372 billion of a total $526 billion.” Further, the Russian government’s budget gets balanced (i.e. its income is equal to its expenditure) at an oil price of anywhere between $100-110 per barrel. Iran’s case is similar. Hence, both these countries need higher oil prices.
As a recent Oped in the Los Angeles Times points out “Russia and Iran compete with Saudi Arabia in the international oil market, and both need oil prices to be at roughly $110 a barrel in order to balance their budgets. If oil prices remain at $80 a barrel, the strategic ambitions of Tehran and Moscow could be severely undermined.”
8) Saudi Arabia also gets hit by a lower oil prices. “Saudi produces close to 10m barrels per day, similar to Russian output. A $20 fall in the oil price, costs Saudi Arabia about $200m per day,” a recent article in The Independent points out.
But Saudi Arabia has more staying power than the others. The fact that Aramco (officially known as Saudi Arabian Oil Company) has deep pockets is a point worth remembering. As Vijay Bhambwani, CEO of BSPLIndia.com recently told me “Saudis can produce low cost arab light sweet crude very cost efficiently and only the recent state welfare schemes implemented after the arab spring, have raised the marginal costs. Even a slight rollback / delayed released of the additional welfare payments (US $ 36 billion) can add sizeable cash flow into the Saudi national balance sheet and give it additional staying power.”
To conclude, there are many different dimensions to falling oil prices and the way each one of them evolves, will have some impact on oil prices in the days to come .

The article originally appeared on www.FirstBiz.com on Nov 13, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Oil prices at a 4-year low: Decoding why Saudi Arabia won’t mind low prices for some time

oil

Vivek Kaul 

Oil prices have fallen to a four year low. As I write this the price of Brent crude oil stands at $82.82 per barrel, down 30% from June 2014.
The latest drop in price has come after Saudi Arabia, the biggest producer of oil within the Organisation of Petroleum Exporting Countries(OPEC), the global oil cartel, decided to cut the price at which it sold oil to the United States by roughly 45 cents to a barrel. At the same time it increased the price to customers in Europe and Asia, for the first time in five months.
The theory going around for sometime has been that Saudi Arabia needs the price of oil to be at least at $83-84 per barrel to balance its budget. Hence, it won’t allow the price of oil to fall below that level. But that as we have seen hasn’t turned out to be the case with the price of Brent crude now less than $83 per barrel.
So, the question is why is Saudi Arabia allowing the price of oil to fall and taking a hit on its income? On many past occasions, the country has cut production when the price of oil is falling. This has helped the country prevent a fall in the price of oil.
As analysts at Merrill Lynch write in a recent report titled Does Saudi Want $85 oil “Our analysis suggests that since 2008, on average, a 10% drop in oil prices has historically led to a 1.5% reduction in Saudi production 3 months later, rising to 2% after 6 months.” Nevertheless, it doesn’t seem to be doing that this time around.
So what has changed? In 2013, United States became the largest producer of oil in the world, displacing Saudi Arabia. The shale oil fields of the United States are producing a lot of oil, and this has helped the country to become the largest producer of oil in the world. This has led to American imports of oil from Saudi Arabia coming down. Data from the US Energy Information Administration tells us that the imports from Saudi Arabia comprised of around 4.6% of total US oil consumption in August 2014. This is down from 7% in August 2013.
In fact, over the last two months, American imports of oil from Saudi Arabia have fallen under one million barrels per day, against 1.4 million barrels earlier. If one looks at the data over a longer period the situation looks even more grim. Over a period of last six years, the production of oil in the United States has increased by 70%. This has led to the reduction of oil imports from OPEC by half. Saudi Arabia is the biggest producer of oil within OPEC.
Saudi Arabia is trying to set this situation right. Shale oil is expensive to produce. Given this, it is viable for companies to produce oil, only if the price of oil remains at a certain level. As the Merrill Lynch analysts point out “With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
Hence, Saudi Arabia is trying to make the production of shale oil unviable for companies which produce shale oil, by driving down the price of oil. The question is how long can the Saudis keep driving the price of oil?
Loren Steffy writing for Forbes.com points out that “The Saudis appear willing to use the abundance of U.S. production to allow prices to keep sliding, enabling the kingdom, which can profit from oil at as little as $30 a barrel, to grab a larger share of the global market.”
While the cost of production of oil in Saudi Arabia maybe low, there are other costs that need to be taken into account. David Strahan in his book The Last Oil Shock explains that that over the years in Saudi Arabia is that as oil prices have gone up, the rulers have been able to run one of the most lavish welfare systems in the world. This has helped them buy political legitimacy and the support of its citizens. For a very long time, the citizens of Saudi Arabia paid no tax, yet had access to free healthcare and education. At the same time, housing, electricity, food and fuel were subsidized. All this was possible because of all the money that was being earned by selling oil. And that is why for Saudi Arabia to balance its budget (i.e. the expenditure of the government is equal to its income), it needs to sell oil at a price of $83-84 per barrel.
Given this, will the Saudis start cutting production and pushing the price of oil up? “Much has been written recently about the marginal costs of production of crude oil, and how much which nation will “hurt” if West Texas Intermediate oil prices fell below the US$ 80 mark,” says Vijay L Bhambwani, CEO of BSPLIndia.com. West Texas Intermediate is the American oil benchmark and is currently at $77.2 per barrel.
Nevertheless, as long as long as Ghawar, Safania, Shayba, Abqaiq, Berri, Manifa, Abu Safah, Faroozan oil fields are viable, Saudis can sustain even lower prices, feels Bhambwani. At the same time, the fact that Aramco (officially known as Saudi Arabian Oil Company) has deep pockets is a point worth remembering. “Saudis can produce low cost arab light sweet crude very cost efficiently and only the recent state welfare schemes implemented after the arab spring, have raised the marginal costs. Even a slight rollback / delayed released of the additional welfare payments (US $ 36 billion) can add sizeable cash flow into the Saudi national balance sheet and give it additional staying power,” adds Bhambwani.
Also, it is worth remembering that the Saudi central bank has reserves worth $734.7 billion. Further, as Edward Chow a senior fellow at the Center for Strategic & International Studies in Washington, recently told Bloomberg “The Saudis ran deficits from the mid-1980s until the late 1990s and may be prepared to do so again.”
What this tells us is that the Saudis can easily sustain low oil prices in the short-term, if they are looking to break the backs of the shale oil companies. At the same time low oil prices will hurt Iran, much to the delight of the Saudins.
To conclude, any fall in price of oil, will benefit India, and help the government further control its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. So, India should hope that Saudi Arabia continues with its current strategy of driving down the price of oil.

The column appeared on www.FirstBiz.com on Nov 6, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)