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.
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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