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OPEC’s Strategy Starting To Take Its Toll On Gulf States

The price of crude oil needn’t be as low as it is today – in the neighborhood of $50 per barrel – except that OPEC decided nearly a year ago to keep it low to in an effort to make shale production unprofitable and restore the cartel’s market share.

The strategy may be working, but it has some unwanted side effects on the cartel’s core producers in the Middle East. Not only are budgets out of balance, but now the region’s stock markets are being affected.

It was the prodigious production of shale oil, mostly in the United States, that caused the price of oil to fall from more than $110 per barrel in June 2014. But it was OPEC’s decision five months later to maintain its production at 30 million barrels per day that drove it to its current low point.

Related: Don’t Expect A Breakout In Oil Prices Any Time Soon

It was a price war declared against shale producers, who rely mostly on hydraulic fracturing, or fracking, to extract shale oil. The process is more expensive than conventional drilling and isn’t profitable if the price of a barrel of crude falls below a threshold of about $60. And the strategy is having its effect on North American extraction.

But it’s also led to lower revenues for OPEC members. The cartel’s pricing maneuver, the brainchild of Saudi Oil Minister Ali al-Naimi, was predicated on rich Gulf States being able to weather a temporary drop in income. When the strategy went into effect, for example, Saudi Arabia’s treasury had a financial reserve of about three-quarters of a trillion dollars.

Not only were less affluent OPEC members such as Venezuela hurt by the lower oil prices, but even Gulf States, including Saudi Arabia, began to feel the pinch almost immediately and revise the projected revenues of their budgets for the fiscal year 2015.

Related: Low Oil Prices Could Persist Through 2016

And on Oct. 30, the U.S. financial services company Standard & Poors (S&P), citing a “pronounced negative swing” in Saudi finances due to lower oil revenues, cut its rating of the Saudi sovereign debt to ’A+/A-1’ from ’AA-/A-1+,’ and said its outlook for Saudi Arabia remains negative.

In announcing the downgrade, S&P observed that the kingdom had budget surpluses of about 13 percent of gross domestic product in the 10 years leading up to 2013. Since the price of oil began its plunge, however, the agency said that surplus will become a deficit of 16 percent of GDP by the end of fiscal 2015.

A downgrade in debt rating makes borrowing more expensive for the affected company or country.

Still, Saudi Arabia probably will suffer little, if any, financial repercussions for two reasons. First, the other two major rating companies, Fitch and Moody’s, have maintained higher ratings for Saudi Arabia. Second, the Saudi government and Saudi-based companies have little foreign debt.

Related: Major Oil And Gas M&A News That Has Yet To Make The Headlines

But the impact on the Middle East overall has already been negative. On Nov 1, stock markets in the region fell because of investors’ concern that the Saudi government will have to reduce spending even further in fiscal 2016 if oil prices remain low to limit its budget deficit.

Markets fell in Saudi Arabia, Dubai, Abu Dhabi and Egypt, though stocks rose slightly in Kuwait, Oman and Bahrain, where trading is traditionally light and therefore less susceptible to market swings elsewhere in the region.

At its last policy-setting meeting in November 2014, OPEC decided to move ahead with its pricing strategy despite what it perceived as its short-term costs. Now those costs may be incurred over a longer term. It will be interesting to see how the cartel addresses the problem at its next major meeting on Dec. 4.

By Andy Tully of Oilprice.com

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  • Khom on December 06 2015 said:
    Lesse...

    10 barrels @ $40 barrel is $400 bucks.

    7 barrels @ $80 a barrel is $560 bucks ($160 more dollars and 30% less work).

    7 barrels @ $60 a barrel is $420 bucks ($20 more dollars and still 30% less work).

    While in the short term some producers with weak balance sheets can probably be knocked out of the game, the techniques for American-style fracking extraction can always come back online quickly if the price makes production compelling.

    So I don't know if the Saudis did enough 'Rousey v. Holm' preparation for the rematch, but there's really not much win for them here.

    They keep production high, and all oil producers suffer and basically have to work their asses off for a fraction of the revenue they used to generate for the same effort. The Suadis have to start going pretty rapidly through their bankroll, even if the wallet is pretty fat, bills are flying out.

    The rest of OPEC and many of the non-OPEC producers who rely heavily on oil basically hate the Suadis. Venezuela is basically condemned to 3rd world status, and probably geo-policial influentially up for the highest bidder. The good times will fade pretty quickly on another year of this 'gambit'.

    But it is a lose-lose situation. When oil is dirt cheap, it will just get gobbled up and passed on to the consumers. Raise the price a bit and all the competitive producers come back online near instantaneously, and the march toward electric cars resumes.

    The jiu-jutsu here is solid. The options here are lose-lose. The opportunities for carving out a relative win due to manipulating commodity pricing belongs to another era.
  • william wiebe on November 02 2015 said:
    This will likely not end well for any of the producers. The purpose of an economic "cartel" is to impose its oligopolic powers on a market to the cartel's price advantage. (Market share is only meaningful if it leads to greater profits). In this regard, it appears that the Kingdom of Saudi Arabia (KSA) and its OPEC faction badly miscalculated the effect of abandonment of OPEC's de facto role as the supply-side market maker.
    First, KSA miscalculated the magnitude of the price collapse - which is costing KSA $9-$15 billion a month in lost revenue (and $1-1.5 trillion dollars a year for the industry as a whole) - I have not seen any compelling evidence that the npv of this forgone income will ever be recouped by the Saudis or anyone else in either increased sales volumes or future pricing (and with every additional month the hole only gets deeper - at this run rate, IMF notes that KSA's foreign reserve would last only 5 years).
    Second, the long-term cost of the increased uncertainty, speculation, volatility and dislocation of the oil markets may ultimately spur, not deter, a shift to alternative energy sources despite lower oil prices – business hates unpredictability (volatility). Moreover, meaningless group OPEC production targets also fosters a continued culture of OPEC members seeking only their individual interests (in a race to the bottom). Under these conditions, restoring a managed marketplace (via restoring individual OPEC quotes, negotiated deal with Russia, Mexico, Brazil, etc. or other non-OPEC producers) will be more difficult - even if the KSA faction of OPEC eventually wants to do so.
    KSA & Co. were mistaken in believing that a 1-2 year (or more) period of low oil prices would safely eliminate its non-OPEC rivals (US shale, tar sands, etc.) and significantly extend the "Age of Oil". While long-term invetments have been curtailed (a plus for OPEC), for many of the long-term/capital intensive producers (tar sands, etc.) OPEC's timing was too late. True, rivals have been forced to cutback dramatically on spending and new production (and some producers many not survive), but the oil controlled by these rivals (or their restructured successors) will not disappear. As we have already started to see, the cost structure of these OPEC rivals may decrease significantly - not only through technological innovations ("necessity" being mother of innovation) and penny-pinching of oil field suppliers and workers, but also from a lowered cost basis of these restructured rivals – neither of which may have happened – or at least not as rapidly. As has been reported, this "Frankenstein" scenario, may mean that OPEC/KSA's actions create relatively low priced tight oil rivals (who can ramp up production in weeks or months with millions, not years or decades with billions) who will become the de facto price setters going forward (not an good prospect for profit maximizing producer/cartel). It is as if KSA thought the "strong medicine" of low prices would kill the tight/shale oil "disease," but instead is more akin to a misuse of antibiotics where the target organism is damaged, but lives and the surviving ones are hardier and more damaging to deal with.... KSA's path may also mean the diminution in the power, influence, (and wealth) of KSA itself - as it is no longer the effective head of a functioning cartel, but instead is just one more commodity producer (albeit a very large and low cost one) seeking to hawk its product where ever it can...
    A far more interesting strategy would have been for KSA & Co to try to use some variation of Game Theory (coupled with a much more robust reporting/monitoring program among OPEC members and maybe even Non-OPEC members alike - Russia, Mexico, Kazakhstan, Brazil, Oman, etc.) to actively manage the growth of new oil in a way that would "balance" the supply/demand marketplace such that OPEC (and non-OPEC producers alike) could maximize profits in a stable controlled market environment. While there will always be a "free rider"/cheating element (and many political, sectarian, legal, anti-trust and other impediments), global technology exists today to monitor oil flow that wasn't available in the 1980s to spot/control cheating... And with the KSA faction's power to "dump" to enforce market discipline, even the US and European Majors might have been tacitly enlisted to make the "right" choice (from a Game Theory Prisoners' Dilemma standpoint) in terms production growth....

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