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Tim Daiss

Tim Daiss

I'm an oil markets analyst, journalist and author that has been working out of the Asia-Pacific region for 12 years. I’ve covered oil, energy markets…

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Should Saudi Arabia Fear Higher Oil Prices?

You have to hand it to Saudi Arabia. After struggling in global oil markets from 2015 to early 2017, the Kingdom can arguably be called “the comeback kid.” However, the question also has to be asked: Can it last?

On Thursday, global oil prices reached highs not seen since late 2014 - good news for oil producers. Brent crude futures broke through the $74 mark and showed little signs of slowing.

Early Thursday, U.S.-traded West Intermediate Crude (WTI) futures increased 62 cents, 0.9 percent, to $69.09 per barrel, reaching highs not seen since 2014.

This increase comes as geopolitical pressure builds, perhaps having a larger impact on prices than even supply and demand fundamentals are.

OPEC and its partners will be meeting in Jeddah on Friday, and again on June 22 to discuss the oil production policy of keeping output restrained in order to continue to drain global inventories and prop up prices. OPEC, led by de facto leader Saudi Arabia, and non-OPEC producers, predominately Russia, agreed in January 2017 to remove as much as 1.8 million barrels per day (bpd) of production to dry up the then supply glut in global oil markets.

Thus far, that plan has worked, sending OECD oil inventory levels back down to the five-year average range and sending prices up enough to alleviate oil markets from their worst price crash in a generation.

However, Saudi Arabia isn’t satisfied with prices in the $70s range, stating yesterday that it would like to see prices in the $80s or even as high as $100 per barrel, a price point last seen in mid-2014 when prices hit around $112 per barrel.

Riyadh needs high oil prices

Admittedly, Saudi Arabia needs higher prices to offset a fourth year of historic budget deficits that has sent the Kingdom rushing to international markets to offer bonds. Riyadh also needs oil prices as high as possible to help insure the highest valuation for the upcoming initial public offering (IPO) of state-owned Saudi Aramco. That valuation could come in as high as $2 trillion, but some analysts claim that a more realistic figure would be around $1.5 trillion or even $1.2 trillion – a valuation too low for Riyadh’s comfort level. Related: Is Saudi Arabia Losing Its Asian Oil Market Share?

But, at what point will the Saudis declare victory in their desire to rebalance the market? A short history lesson from 2014 should help.

As prices soared to unprecedented highs, U.S. shale oil producers joined the party and flooded the market. The Saudis retaliated by not playing its historic role of swing producer and putting the brakes on oil output, instead deciding to pump at all costs. This of course, flooded global oil inventories. Industry layoffs ensued, company valuations plunged and prices tumbled downward, falling below the $30 level by early 2016 – dark times for all.

The lesson here? Higher prices do not always correlate to a healthy global oil market nor are they always advantageous for producers. In fact, an argument can be made that they are detrimental.

The Saudis can argue that with OECD inventory levels at five-year averages and with non-OPEC producer Russia still on board as a partner in managing production, it can manage or micro-manage the situation better this time.

Derailing factors

While this is seemingly giving Saudi Arabia confidence, several factors could derail their renewed sense of calm. The Saudi led oil production agreement could still fall apart. Iran, for its part, could pull out amid tensions with Saudi Arabia in Syria, Yemen and elsewhere.

Russia could still change its mind about the production cut deal, especially as more U.S. sanctions seem to be headed their way. Moscow still needs petro-dollars and Putin needs them to maintain his power play in the country and the region.

U.S. shale oil production, which is projected to reach 11 million bpd by the end of the year, will still be the primary threat if prices come anywhere near the $100 price point.

Though the Saudis and Russia have a history of downplaying the impact U.S. shale oil has on markets, U.S. shale oil producers have one distinguishing advantage over conventional producers – impressive initial production rates (IPs), usually much higher than IP rates for conventional wells. In fact, the IP for shale wells can be between three to ten times that of conventional wells, sometimes more.

The IP rates for shale oil producers in the U.S. can even be so large that producers generate enough cash in the first one or two years to earn back the entire investment of the well. Though shale wells admittedly do have step decline curves, these steep decline curves have no bearing on how high oil prices initiate new should oil production. Related: Canada’s Oil Patch To Turn Profitable In 2018

Shale oil production economics explains why anytime oil prices start to tick upward, the number of drilling rigs in the U.S. increases in lock step. If prices breached $80 per barrel with indications that it could head toward $100 per barrel, the number of new drilling rigs coming into play in the U.S. would kick in and much of OPEC’s recent work on reducing OECD oil inventory levels would be put in jeopardy.

On April 18, Baker Hughes GE reported that U.S. crude oil rigs increased by seven to 815 for the week of April 6-13 - the highest level since March 20, 2015. The rigs also increased by 132 or 19.3 percent year-over-year.

If the number of rigs has increased by nearly 20 percent amid oil prices over the last few months, how many more would be added if oil prices reach between $80-$100 per barrel? It’s a question that Saudi Arabia should consider in its drive to put more upward pressure on oil prices.

By Tim Daiss for Oilprice.com

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  • Mamdouh G Salameh on April 19 2018 said:
    Saudi Arabia and for that matter other OPEC members and also Russia don’t fear higher oil prices even if they exceed $100 a barrel as long as the global economy tolerates that level of prices.

    A sound economic principle is to maximize the return on one’s assets to whatever level the global oil market can tolerate. With Saudi Arabia and other OPEC members sitting on more than 65% of global proven reserves, this principle should be their guiding strategy on oil prices.

    Saudi Arabia and the majority of OPEC members need an oil price higher than $100 to balance their budgets. To achieve this goal, they have to bolster the current positive fundamentals in the global oil market by extending the OPEC/non-OPEC production cut agreement well into the future. This could be in the form of a permanent mechanism flexible enough to react quickly to a tightening in the oil market or a build in crude oil and gasoline inventories.

    Iran can’t derail the OPEC deal even if it pulled out of it. Iran can’t increase its production beyond current levels of 3.6-3.7 million barrels a day (mbd) so any threats by Iran will be empty ones.

    Russia and Saudi Arabia have been the two architects of the OPEC deal and are both committed to long-term cooperation to stabilize the global oil market in their capacity as the world’s top two oil producers and exporters.

    Moreover, US sanctions on Russia have no bite as can be seen by the growth of the Russian economy. The author is wrong to say that Moscow needs petrodollars. In fact, Putin was the single most important factor that has been undermining the petrodollar since the US imposed the first sanctions on Russia in 2014. Russia was a major supporter of the successful launching of China’s petro-yuan which is challenging the petrodollar for global oil dominance.

    For the last five months, I have been saying that Saudi Arabia will eventually withdraw the IPO of Saudi Aramco since it no longer needs it financially particularly with the rise in oil prices. Moreover, its valuation of the IPO will not be accepted at face value by investors without independent auditing of its oil reserves. To this could be added the risk of US litigation. My own estimate of the IPO ranges from $35-$50 bn calculated on the basis of remaining Saudi proven reserves of around 58-93 bb and a price of $70/barrel giving a valuation of Saudi Aramco of $700 bn to around $1 trillion.

    The threat of rising US shale production has already been factored in by the global oil market as more of a hype than a reality.

    The greatest advantages conventional oil producers have over shale oil producers are much cheaper production costs ($4/barrel in Saudi Arabia and the Gulf region compared with $50-60/barrel for Shale oil) and far less depletion rate amounting to 3% per annum compared with 70%-90% in the first year of production for shale oil wells. This means that shale oil drillers have to drill 10,000 new wells annually at a cost of $50 bn a year just to maintain production.

    Dr Mamdouh G Salameh
    International Oil Economist
    Visiting Professor of Energy Economics at ESCP Europe Business School, London
  • Joe on April 21 2018 said:
    Let’s put some numbers to those “ steep decline curves”. Now that the 2017 data is in, we know the average Permian basin well starts producing at 500 bbls per day. The data also shows the average Permian wells drilled prior to 2014 are now approaching less than 20 bbls per day. They are now racing against their decline curve. Efforts to replace production will start to dominate the need for capital. The Saudi’s are no longer worried about US oil production.

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