Power in today’s oil market

Amidst the din of analysts speculating about whether oil prices will rise or fall, observers may well be overlooking some pressing questions about the very nature of the global oil market. The most significant of these questions relates to whether Saudi Arabia is losing its grip on the global oil market and if U.S. oil and gas producers are replacing the Saudis as the key global swing producer.

By the mid-70s, the Kingdom of Saudi Arabia wielded the power to swing oil prices at its will by turning on and off the taps. Presently, after 44 years, the scenario is quite different. In fact, the recent Vienna accord where OPEC and NOPEC producers agreed to cut 1.8mbpd of oil, and now its possible extension, is symptomatic of the internal weakness. In 2014 when Saudi Arabia refusedr to cut production to stabilize prices, and instead increased production to protect market share, an oil price war began. But the strategy to drain out the high cost producers has gone awry. U.S. production continues to rise, while Saudi Arabia’s economy is suffering from lost oil revenue. U.S. Shale producers appear to be recovering market share and have managed to lower breakeven prices through a technological revolution.

Welcome to the era of “Fracking 2.0”, where a “company man” 100 miles away from an oil rig can give instructions to his workers via an app called “ISteer.” EOG Resources, one of the largest independent oil and gas companies in U.S. and ranked as Texas’ fifth largest gas producer, is doing wonders as it outperforms its competitors. EOG can now drill horizontal wells in just 20 days, which is down from 38 in 2014. The company has pumped consistent quantities of oil irrespective of the drop in prices. And that is just one example.

At the same time, the production cost per barrel of oil for U.S. shale operators has decreased. Rystad Energy says that the break-even cost for U.S. shale is now $35 per barrel. Only recently such costs were three times higher than the Middle East and other non-Western producers and the depletion rate for such producers were much more punishing. But now the recovery rate, from 5%to 12%, may reach 25% in coming years. It is not a matter of if but when this technological revolution extends across all oil-producing regions outside the Middle East. There is strong evidence of the aforesaid rising oil production as well, with the EIA forecasting a U.S. daily crude output of 9.2 million barrels this year. It is expected to reach 9.7mpd in 2018. The rise in oil prices and U.S. production are directly proportional. This is one of the reasons that, as prices have recovered over past few months, we have witnessed a historic build in inventories.

While the U.S. experiences this continued growth, Saudi Arabia has no option but to curb production and stabilize oil prices as more than 90% of their revenue depends on oil exports. In 2015 the Saudi’s were burning through their foreign exchange reserves at a perilous rate, which can create inflationary pressures. Saudi government subsidies and public entitlements were reduced while salaries and holidays were cut. The Deputy Crown Prince, Muhammad Bin Salman, faces an important and difficult task: stabilize the economy or face popular unrest. Therefore, the Kingdom, in an effort to wean itself off oil, launched “Saudi Vision 2030” and the “National Transformation Plan 2020.” The planned IPO of Saudi Aramco, the Kingdom’s national oil company, is a part of the Kingdom’s recovery strategy. By selling a 5% stake of this company, which according to some estimates is worth one trillion U.S. dollars (enough to buy Google, Apple, Berkshire Hathaway and Microsoft combined), the Kingdom is set to create the world’s largest sovereign fund. Such a step would diversify its economy and possibly eliminate the Kingdom’s greatest threat: social unrest. And now that there is a production cut with a more than 90% compliance rate, the Kingdom may be feeling more secure. In fact, according to reports, the Saudi’s economy has started to recover.

The OPEC deal, which was set to expire after the first six months of 2017, is likely to be extended for another six months which, given the importance of oil prices for Saudi Arabia’s economy, may mean the difference between survival or destruction. Another positive move from Saudi Arabia is the reduction in tax rate for Saudi Aramco from 85% to 50%. This will help in ramping up Aramco’s value, which is the main revenue earner of the country. Saudi Arabia appears to have come to terms with the fact that it can no longer control the oil markets, and instead is focused on attempting to protect its economy.

Rising rig count, ballooning inventories, advances in shale technology and the already present supply glut. These are few of the signs that, notwithstanding the efforts by the OPEC producers to stabilize markets, the fundamentals remain unchanged and U.S. producers are regaining their strength. If the trend continues, will we see the U.S. emerging as a new swing producer? In the world of oil there may well be two swing producers now. One is young and growing while the other is struggling to keep up with the times.