OPEC is caught between shale and a hard place.
Saudis, Russia, shale. That is all ye need to know in order to understand the oil market. The Saudis lead the OPEC oil cartel, Russia is their largest potential fellow traveler, and the Permian Basin in the Southwest is the oil-rich shale that stands between the other two and $100 per barrel oil.
There was a time when the Saudi-led cartel of 13 oil producers could more or less control the price of oil. If the market got so high as to encourage the development of alternatives to oil, the Saudis would open the taps and increase production to bring prices down. If prices fell to unacceptable levels, Saudi Arabia and its partners would agree to production cutbacks, and stabilize or boost prices. Russia would or would not cooperate, depending on its need for cash.
A funny thing happened on the way to continued dominance. A new technology known as fracking gave U.S. producers access to vast reserves embedded in shale formations, largely in the Permian Basin, which sprawls across the western part of Texas and the southeastern part of New Mexico. The Saudis decided to consign the frackers to the scrap heap of history by opening their valves, flooding markets with oil, driving prices so low that the frackers would go bust. It worked. For a while. Prices, once at $100 per barrel, fell to $25. Then a second funny thing happened. And a third.
The Saudi regime found that it was running out of cash with which to finance the elaborate welfare state that keeps its people sullen but not mutinous and supports the lifestyles of some 5,000 princes. Then frackers upped their technological game and drove their costs down to a point where they didn’t need $100 oil to survive, but could make a decent profit at $40 per barrel or far less.
The combination of these developments led the Saudis to abandon efforts to drive American producers from world markets and to persuade OPEC members to join them in curtailing supply. Better still from OPEC’s point of view, some dozen non-OPEC members, led by Russia, agreed to cooperate by cutting their own output. The cartel and its fellow travelers decided to reduce output by 1.8 million barrels per day, with the nonmembers taking the burden of a 600,000-barrel-per-day cut. And prices did rise to over $50 per barrel, not the $100 of the good old days, but twice the $25 of the bad old days.
But pledges to cut production and actual production cuts are two different things. In the event, OPEC members, most notably Iraq, exceeded their quotas by so much that the Saudis had to reduce daily output by 300,000 barrels more than the 800,000 they had promised in order to keep total OPEC production roughly in line with the cartel’s target. And Khalid Al-Falih, the man in charge of Saudi oil matters, was shocked, shocked to learn that Russia was reducing its output by only one-third of the amount it had pledged. Reports from a recent industry meeting in Houston say Falih “expressed his frustration” with Russia and Iraq; “he was really fed up.”
Add U.S. output, about which more in a moment, to the flow of oil hitting the market, and prices fell below $50 a few weeks ago and have remained there. This distressed the Saudis, who need $50 oil if they are to accomplish three objectives: support the royals in the manner to which they are accustomed; keep their young people passably contented; and maximize the value of their planned initial public offering of a portion of Saudi Aramco.
First, the royals. When the price broke below $50, King Salman was touring Asia. According to an industry database maintained by Rystad Energy UCube, the average cash cost of producing a barrel of oil in Saudi Arabia is less than $10, so the king felt no need to curb his desire for company, his need for a bit of excess baggage, and his preference for an aircraft in which he can stretch his legs. He did not panic. No one from his entourage of 1,500, which included 25 royal princes, was sent home. Excess baggage charges for the 505 tons of luggage he was toting were borne manfully. After all, this is a man whose predecessor reportedly spent $100 million in Marbella on his seven-week vacation to cover the cost of his 3,000-person entourage, a fleet of jumbo jets, 100 new Mercedes transported from Germany, and sundry other necessities.
Second, the young Saudis. Although $50 oil is sufficient to enable the royals to maintain their living standard, it is the bare minimum needed to continue to anesthetize the unemployed young Saudis with government benefits: About half of the native population of 33 million is under the age of 25. Most young men and, of course, women have never worked, are not trained for jobs, and anyhow prefer government handouts. One who had taken a private-sector job told the New York Times, “It is good experience,” but “the days are long and you can’t even go out to smoke.”
Third, the impending IPO. The Saudis would not like to be peddling shares in the midst of a price war. They want a stable price in the area of $50 (higher would be better) to support the proposed initial public offering of a 5 percent stake in state-owned Saudi Aramco, an enterprise they expect the market to value at $2 trillion.
In short, the price of oil is not a mere price for the Saudis. It is the determinant of the long-run survival of the current regime: its ability to prevent its young from attempting to shake off the social restrictions imposed by the theocracy; its ability to keep the over eight million foreign workers in the country sufficiently satisfied and controlled not to join radical groups; its ability to finance its economic development plan to reduce its dependence on oil revenues; and, of course, its ability to continue financing the spread of the fanatical version of Islam on which ISIS relies for such legitimacy as it has.
Which is why the Saudis tried to stamp out our fracking industry. And now probably wish they hadn’t. For by driving prices down to $25 they forced American oilmen to take a cleaver to costs. Scott Sheffield, CEO of Pioneer Natural Resources, known as “King of the Permian Basin,” reckons he can earn a 15 percent return with oil selling at “sub-$30” per barrel.
And it is oil with two key characteristics. First, there is a lot of it. Estimates of the total amount and of the portion that is economically recoverable vary widely, but for our purposes we need only note that there is enough oil in various shale formations to keep a lid on prices for a very long time. Second, for technological reasons too complicated to describe here, shale oil production can be switched on and off with relative ease. Prices drop, shut down high-cost wells; prices rise, bring them back online and drill new ones. When prices rose from their $25 floor, U.S. output rose by 600,000 barrels per day, offsetting one-third of the planned Saudi-led cut. “Nobody was expecting U.S. shale oil production to pick up so much and so quickly,” said Gnanasekar Thiagarajan, director of Commtrendz Risk Management. And exports of U.S. crude, never much of a factor in the past, are now running at over 1 million barrels per day.
In short, the OPEC cartel can no longer control the price of oil to the extent it once did.