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Saudi Arabia’s Fake Surrender: Why The Oil Price War Is Still On

Saudi Construction

What do you do when everyone is bugging you to do something, but you don't want to do it? The simple answer is that you make it look like you are doing something in order to get others off your back.

It is not always easy to tell what people's intentions are. But we can look at what they have done in the past. The main thing that the Kingdom of Saudi Arabia has done over the past year, in response to pressure from other OPEC members, is talk about steps it would take to raise oil prices. But in the end the kingdom doesn't actually do them, or it does things which have no practical significance. (Saudi Arabia, the world's largest exporter, is the OPEC member with the greatest flexibility in its production. Any OPEC production cut without Saudi leadership would lack credibility.)

We should keep all this in mind when evaluating the latest reports that OPEC has agreed to cuts. Bloomberg tells us right up front that OPEC has merely agreed to the "outline of a deal" that will be taken up at its November meeting.

One of Saudi Arabia's partners in its yearlong public talkfest has been Russia, the number one or number two oil producer in the world depending on what month it is. The Russians said in early October 2015 that they were ready to discuss oil prices with OPEC. Later that month it was leaked that the Russians had no intention of cutting their own production. In late January of this year, the oil price catapulted after Russia's energy minister said he was "ready to meet with OPEC and Saudi Arabia to discuss a production cut," the Financial Times reported.

When the Russians did meet with Saudi Arabia and also with representatives from Qatar and Venezuela in late February, the group proposed a freeze in production, but no production cut. Only the uninitiated may be forgiven for not understanding that a freeze would change nothing. Oil production would simply continue at the current level, hardly a strategy to achieve higher prices.

In early March the Russians announced that their oil companies agreed to a freeze in production. In late March the Saudis announced that they, too, would be freezing production even if Iran would not commit to a similar freeze. The Iranians, of course, have been keen to get back into the export market in a major way after having been crippled by trade sanctions for years, sanctions which have been lifted in the wake of an international agreement governing Iran's nuclear program.

Related: Russia Nears Completion Of First Floating Nuclear Plant

The stated intention of the Saudis and the Russians was to raise oil prices. But, given that the practical effect on production was zero, they must have had some other method in mind. One possibility is that they have been working together simply to jawbone the price of oil higher without having to reduce production. If that's the case, it seems to have worked reasonably well as all the announcements of meetings and rumors about what might happen at those meetings seem to have coincided roughly with a rising price.

It's also possible that the Saudi-Russian tag team has been trying to kill two birds with one stone. These producers might also have been seeking to keep market participants guessing about the future of prices so as to dampen investment in U.S. shale-based operations, operations which have helped to create an excess of oil on the market. Uncertainty breeds fear, and fear keeps investors away. By making periodic announcements about cuts and freezes followed by rumors or statements that undermine the original announcements, they are creating the requisite uncertainty.

In April OPEC and other producers discussed a freeze, and then the very next day failed to implement one. In mid-August, the Saudi oil minister was quoted as saying that OPEC members would consider "any possible action" at a meeting the following month. This rather mild statement was followed by a 4 percent rise in crude prices.

The record of Saudi announcements and actions suggests they are not serious. In fact, shortly after the recent announcement that OPEC would be cutting production, Saudi Arabia lowered prices for its crude, a move not consistent with its stated aims. The OPEC agreement to cut production, the first in eight years, may not actually deliver any results given that Iran is exempt, that a production range was adopted, and that OPEC members routinely cheat on quotas.

Related: The Rebirth Of Egypt’s Oil And Gas Sector

But, of course, the Saudis know all this. The question is whether they care. It turns out that the Saudis have not finished the job they set out to do, a job which few commentators have properly understood. The kingdom has been seeking not merely to lower the production of oil from U.S. shale deposits--a goal which they've already achieved--but also to cripple funding for new projects.

As oil hovers around $50 per barrel, investors continue to plow additional funds into shale drilling, particularly the Permian Basin in Texas. There may indeed be wells there that will be profitable at this level, but not an unlimited number. Other shale areas such as North Dakota have seen drilling activity slow to crawl.

What the Saudis want is for investment money to dry up. In order for that to happen investors in U.S. shale have to feel more pain--so much pain, in fact, that they won't be eager to jump in again even as prices rise.

That's why I don't believe the announced oil production cuts will ultimately have any noticeable effect on production--because I think the Saudis don't want them to. While some commentators contend that Saudi Arabia is surrendering in its war on shale, I believe the kingdom is merely giving everyone another head fake just as they and the Russians (and now the Algerians) have been doing all year.

They got a 5 percent bump in the oil price on the day of the recent production cut announcement and total of about 11.5 percent through Friday, October 7--all without actually cutting production by one barrel. Now, that's a pretty effective head fake. What I can't figure out is why more people aren't on to this.

By Kurt Cobb via Resource Insights

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  • Kumar on October 10 2016 said:
    Author has laid down the topic so gracefully the game of Saudis and Russia. I certainly do agree with the conclusion.
  • Terry Vendetti on October 11 2016 said:
    If you are to believe the author of this article then perhaps OPEC has developed the same strategy employed by the Federal Reserve regarding the possibility of raising interest rates without actually doing so. Jawbone the market while not actually doing anything has worked for the Federal Reserve so maybe it will work for OPEC as well. Of course there is the small detail that OPEC members have lost 1 trillion dollars in revenue over the past three years as a result of lower oil prices. While some OPEC countries can afford to pump oil at lower prices the reality is that their budgets are based on oil trading at higher levels than today.

  • steve from virginia on October 11 2016 said:
    Regardless of Saudi or Russian intentions, the customers -- who borrow to pay for their oil use -- are broke. They were broke two years ago they are more broke now, they lack the means to support higher prices.

    Cutting output will not make customers wealthier, instead it will accelerate the decline of the oil extraction business.

    The funding loop: banks (credit failure) => customers reliant on loans => refiners (who cannot sell their products) => drillers and distributors => back to banks. The entire oil industry is dependent upon bank lending to customers for top-line revenue and cash flow; the entire industry is insolvent.

    The process has been underway since 2014 oil @ $50/barrel and there are crying sounds emitting from credit as 'this bank' and 'that bank' tremble at the lip of liquidation. You can pick your banks, there are many to choose from. A few months ago it was $65/barrel that was causing agony in credit. In 2014 it was $115/barrel. Next year it will be $40. When it is $20 there will be no more oil in any market if for no other reason the $20 oil has been 'used' already and there is none left.

    This is energy deflation, where the overall shortage of oil boosts the numbers of broke customers. Extraction costs gallop out of reach as the customers' reach becomes shorter.
  • Bud on October 11 2016 said:
    This talk is all nonsense. For the past 50 years the Saudis and the U.S. Treasury have had an iron grip on oil. The Saudis increased production by a million bpd in 2014 when the U.S. Was on pace to drill 50k oil&gas wells per year. The could reverse that and more in a matter of weeks if they desired. The democrats are more interested in low gas prices than they are supporting republican voters in the Oil fields during an election cycle as well.

    But this has run its course. And to the authors point regarding finance, the SEC PV10 math, which causes oil firms to write down assets and thereby impair borrowing and thus drilling has run its course as well. If you understand what I just said and you don't comment on it you are well you know, and if you don't then you should write on another topic.
  • Matthew Biddick on October 11 2016 said:
    I agree Terry. The bottom line is the bottom line. One can "jawbone" about strategies and motivations all one wants, but in the end, no person, company, or country can continually live off of a savings account. Got to start putting something back into the savings account sometime. The Saudis need much higher oil prices than $50/b.
  • jack ma on October 11 2016 said:
    Russia and Sa are both forced to raise money for budget shortfalls so they are selling parts of state oil assets in 2017. They need 70 oil before the IPO. This is just common sense. JM
  • odysseus on October 11 2016 said:
    You know who kick started OPEC?
    And Kaddafi ain't doing so well. The kingdom is more vulnerable than the price reflects.
    Actually, it is worse. The Wahhabi genie is out of the bottle: Muslim Brotherhood, ISIS, you name your next jihadi gangster. The kingdom's days are numbered.
  • Noah Katz on October 12 2016 said:
    > The Saudis need much higher oil prices than $50/b.

    This and other statements like it seem to imply that because their strategy to drive shale produces out of business failed, they can change their strategy to one of production cuts.

    They can try, but the world has changed and there are far more uncontrollable sources of oil than there used to be, in addition to OPEC's own members who can be counted on to cheat even if all of the jawboning resulted in an actual agreement.

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