What Is Saudi Arabia’s Best Oil Strategy?

There appears to be little appetite amongst OPEC members and Russia for further production cuts, despite the gradual slide in oil prices. Russia is reported to have reduced output by slightly less than had been agreed upon by the OPEC plus producer group in August, while OPEC overall saw production up by 80,000 b/d to 29.61 million b/d, according to a Reuters poll published August 30.

Both Iraq and Nigeria boosted output - the former by 60,000 b/d and the latter by 80,000 b/d. The new head of the Nigerian National Petroleum Company, Mele Kyari, said at the end of August that Nigeria could increase output fairly easily next year to 2.5 million b/d, by bringing production stranded by pipeline damage back on-stream.

At the same time, production from Iran and Venezuela appears to have reached minimum levels, while Libyan output is being sustained at around the 1 million b/d mark, despite the ongoing civil war. This means that even if Saudi Arabia can get the OPEC plus group to agree to more stringent reductions, the burden of achieving those cuts will land hardest and squarest on Saudi shoulders.

Further costs

OPEC's oil price support via production cuts has always been a double-edged sword. Higher oil prices stimulate non-OPEC oil activity, notably US shale oil, and the US oil patch appears to be struggling. Further OPEC reductions could throw it a lifeline.

The US oil rig count has trended downward since a peak in November last year of 888 to reach 742 at the end of August. The number of bankruptcies is on the rise. Lawyers Haynes and Boone reported in August that 26 US oil and gas producers had filed for bankruptcy so far in 2019, compared with 28 over the whole of 2018.

With high cash requirements to keep production going, shale drillers are finding lending hard to come by in a low-price environment for both oil and gas, the twin products of shale drilling.

This is not the US shale patch burning through its resource. It reflects the over reliance of US shale firms on debt to sustain production. Once market sentiment turns against them, in the form of low expectations of future returns, those companies most over extended are quickly exposed.

Moreover, there is no single breakeven price for US shale.

While some shale production can survive at $40/b and below - the most efficient drillers on the best acreage with the least debt - a WTI oil price under $60/b, combined with Henry Hub gas below $3/MMBtu, and much lower at some regional hubs, also pushes the least efficient drillers, drilling poorer acreage and laden with debt, over the edge.

At the same time, the rapid expansion of US oil and gas production has eaten into the pre-existing slack in the drilling services market. By July last year, the number of available land rigs had dropped to about 18% of marketed rigs and the average day rate for all classes had risen from $14,000 in November 2016 to above $16,000, squeezing drillers' margins.

This trend has since gone into reverse as drillers exercise more financial discipline and the active rig count drops. But it will take time to restore margin lost to service contractors during the period of rapid expansion.

While Saudi Arabia may interpret signs of fragility on the US oil patch as evidence of the success of its policies, the tendency has been for US retrenchment rather than collapse. Chapter 11 filings may sound dramatic, but the chance to re-order debt means there is seldom the impact on production that might be expected. Drillers pass on the pain to debtors and service contractors, creating a strong incentive to find efficiencies all along the supply chain.

Riyadh's conundrum

But for Riyadh the current slowdown may be viewed as enough for now when set against the costs of a more dramatic change in policy - a production free for all could pay long term but would have a disastrous short to medium-term impact on petro-economies' revenues. Further cuts will fall hardest on Saudi Arabia, potentially test to its limits the cohesion of the OPEC plus group, while the benefits will be spread around universally, including to US shale drillers.

The goldilocks zone for Saudi Arabia in terms of achieving a balance between price and market share appears to lie somewhere between $55-$60/b Brent, assuming a $5-6/b premium for Brent to West Texas Intermediate, but in terms of its intended Initial Public Offering for state oil giant Saudi Aramco, Riyadh would prefer an oil price significantly north of $60/b Brent.

Give the current trade environment and growing concern over the health of the US economy, this is not a conundrum Saudi Arabia can currently resolve. A gradual downward drift - barring any flare up in Gulf tensions - might be the best that can be achieved for the moment and preferable to the costs of any dramatic loosening or tightening of policy, the Aramco IPO notwithstanding.