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Crude Economics
Saudi Plays Chicken with U.S. Shale

The benchmark for American crude, called the West Texas Intermediate (WTI), fell below $80 per barrel for the first time in more than two years in trading today before staging a small rally. Similarly, Brent crude, Europe’s benchmark, traded below $83 per barrel, a four-year low, before seeing a slight rebound on what Reuters explains to be “technical buying ahead of options expiry for U.S. crude oil and contract expiry for Brent crude.”

But temporary rebound notwithstanding, there’s no denying that this is a bear market for crude oil. Brent prices have dropped by more than 28 percent since June, while WTI has tumbled nearly 25 percent in that same time period. Weak demand has collided with an oversupplied market, partly due to Libyan supplies coming back online after protracted disruptions, and, of course, in part due to booming supplies out of the suddenly shale-rich America.

The question on everyone’s minds is, where is OPEC? The cartel of petrostates has colluded in the past to cut production to keep prices artificially high, yet the organization’s largest producer and, historically, the one most likely to take the lead on these cuts—Saudi Arabia—has cut prices, not production, in recent weeks.

The Saudis have actually offered discounts to customers, especially in Asia, in a bid to gain market share in the midst of this price rout. Kuwait wasted little time in following suit, and, somewhat surprisingly, Iran even joined in, saying it could live with lower oil prices. With the exception of Iran, the countries seemingly most content with declining prices are also the ones with relatively low breakeven prices—that is, the price at which these petrostates need to sell their oil in order to balance their budgets.

Venezuela, a country teetering on the brink of default, needs to sell its black gold at $121 per barrel just to stay in the black. Caracas has been outspoken about its calls for an emergency meeting of the cartel, too impatient to wait for OPEC’s already scheduled meeting in late November. Those calls have fallen on deaf ears, and, as the WSJ reports, many analysts think OPEC won’t choose to cut production when it meets next month:

Continued opposition by Saudi Arabia, Kuwait and the U.A.E., however, now makes any cut highly unlikely. Gulf nations worry any reduction in the limit on OPEC production would lead to them losing share in global oil markets, the people familiar with the matter said, even if that means oil prices keep dropping.

“Saudi Arabia and the rest of the Gulf countries have no intention whatsoever to accept the idea of a cut at the November meeting,” one Gulf OPEC official said. “If we are going to end up with lower market share and prices will fall anyway, let’s stick to market share.”

There has been some speculation that the Saudis may be looking to abdicate their role as OPEC’s (and therefore the world’s) de facto swing supplier, banking on the fact that U.S. shale producers, the new kids on the block, will soon have to cut production because fracking will cease to be profitable. America’s unconventional oil drilling tends to be more expensive; the IEA recently announced that at $80 per barrel, 96 percent of shale drilling would still be profitable, but if WTI prices were to dip much lower, the shale boom would hit a considerable hurdle.

We’re not there yet, and in fact the price of oil today exists in a kind of sweet spot: high enough to continue to incentivize U.S. fracking, but low enough to benefit American consumers (average gas prices in the U.S. are at their lowest level since 2011) and stymie some of America’s geopolitical opponents. Russia, for example, needs oil to trade above $100 per barrel to balance its budget.

The Saudi strategy isn’t unlike a game of chicken. The Saudi breakeven price hovers around $93 per barrel, and while it can afford to operate in the red to gain market share for now, it may not be able to do so in the long term. Banking on American shale production cuts may be a bigger gamble than the Saudis expect, too: it will take some time for the market to shift and fracking to draw down, even if prices continue to plunge.

And U.S. shale has a final trump card: innovation. Though fracked wells have steep decline rates, drillers continue to optimize rigs and maximize output while minimizing costs. Bloomberg reports that shale firms have driven costs down by as much as $30 per barrel since 2012, and one analyst surmised that “[t]he profit margin on most commercial unconventional oil plays will support prices as low as $50, many below that even.”

It’s difficult to predict what happens next, but for now, the United States seems to be sitting pretty while many of the world’s petrostates—including a number of America’s geopolitical adversaries—are feeling the pinch. We’ll be watching.

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  • Corlyss

    Oil has a lot further to drop before it discourages shale drilling. Can the Saudis ride it down?

  • dfooter

    And oil is a small fraction of our economy, but the mainstay of the Saudi’s, Russia’s, Venezuela’s, Iran’s etc.

    • dwpittelli

      Yes. I think that’s the logic behind showing “breakeven” prices for those countries as the price where the government budget isn’t in deficit, while breakeven prices for US wells are discussed for the wells themselves. (There is no oil price where our federal government would be in the black.)

  • Jacksonian_Libertarian

    “And U.S. shale has a final trump card: innovation. Though fracked wells have steep decline rates, drillers continue to optimize rigs and maximize output while minimizing costs. Bloomberg reports that shale firms have driven costs down by as much as $30 per barrel since 2012, and one analyst surmised that “[t]he profit margin on most commercial unconventional oil plays will support prices as low as $50, many below that even.””

    I’m glad to see you are listening to me, instead of just taking the stupid government predictions from the IEA or EIA who are always wrong. Shale oil production costs are falling at $10 per barrel per year, and OPEC production costs are actually rising from aging wells, and don’t reflect the fact that oil profits are used to fund their governments. I’ll put my money on the shale oil developers continuing to eat OPEC’s lunch for many years.

  • FriendlyGoat

    This all sounds as though TAI believes the OPEC nations will play production-level games on any whim to influence prices, but that USA frackers would NEVER do such a thing. Get back to us when we hear the USA producers making noise about low prices, okay?

    • mc

      Why in the world would you think US shale producers could get away with such a thing? They know the country and the government would laugh at them. If you believe that interests dependent on unconventional oil would conspire to force the government to support prices the correct response is to deprive the state of the power to set that price. As for shale producers, it is only in an inside-down world, by a deranged, meth-addled conspiracy theory, that they might set the price at which their product is sold.

      • FriendlyGoat

        I’m not saying the shale producers can conspire to get the government to do anything. I’m saying they too will reduce production if they believe the price is going too low for too long.
        They’ll talk about it in the media before they do it.

        There is some low price level at which they would really lose money to keep drilling. There is a higher level at which they will be complaining about half or more of the profit being gone.

        • GlendaleGreyBeard

          Look, the thing about oil is that you can’t eat it, sleep with it, or live with it. When it comes out of the ground, it has to find a home at whatever the price level is. Oil prices are set in a world market, and that’s been true since the first Arab Oil Shocks. Oil will not be produced from any particular well if the cost of production is more than the price it sells at. You don’t lose money and make it up on volume.
          Now as for the ability of the government to set the price for oil, look at the Texas Rail Road Commission and its proration order system in effect from the early 1930’s to 1970 or so. At a time when US oil fields were the dominant producers in the world, the Texas Rail Road Commission set the price of West Texas Intermediate at $3 a barrel and it stayed fixed at the price for 30 plus years. The Commission told producers what percentage of maximum capacity production they could have in each field “pro ration”, to have supply meet demand at $3 a barrel.
          Along came the Arab Oil Shocks and OPEC and the Opeckers decided to set the price by cartel agreement–rationing supply to meet demand at the agreed on price. That worked so long as cartel members didn’t cheat. But in the nature of things, some cartel members will eventually cheat by producing more than their agreed upon share–and the cartel will break down.

    • Mastro63

      They can’t do that- its illegal- what OPEC does violates US anti-trust laws.
      Also- the frackers compete with each other- the Sauds don’t (Saudi Arabia is basically all ARAMCO). ARAMCO can cut production- but if a Pennsylvania fracker cuts back- a Texas fracker will just laugh.

  • Despiser_of_Libs

    Pure unadulterated CRAP… The Leftists have an election to sway and what better way than a miraculous drop of Gas prices. Ya know because the last 6 years of $4 gas was in YOUR best interest and all, according to Libidiots anyway… Im not buying it…

    FASCISTS are America gravest threat…..

    • dwpittelli

      And I remember leftists saying the same of Bush 10 years ago. I doubt it, in either case. What exactly do you propose is the method by which President Obama is getting US oil supplies to increase right now? Or by what invisible means is he bending the laws of global supply and demand?

      No. President Obama is the lucky recipient of the benefits of increased North American production, even though Obama has opposed production everywhere he can (notably, on federal lands, and by not allowing Keystone).

      • Mastro63

        Agreed- I remember a veteran asking W Bush if he could lower gas prices and W basically had to answer “NO”

    • PDX_traveler

      Keyboard caps lock key getting flakey, buddy?
      Relax, it’s only you and a few others who are idiots, so the country is still relatively ok…

  • ToursLepantoVienna

    Please reference a source for your claim the breakeven point is $95 for the Saudis. That seems ridiculously high.

  • douginsd

    The Saudis may have figured out it is cheaper and more effective to flood the world with oil than to get in an arms race they might not win with their regional adversaries, especially given their smaller population base. Being the low cost producer does have its advantages.

    • Mastro63

      They actually buy many of their weapons with oil. Their big weapons deal with Britain was for oil- not cash.

      I believe they had serious problems when oil prices fell in the Eighties and the ’90’s too.

  • Mastro63

    US shale also has the falling shoe of NY state production- its tied up by red tape now (supposedly earthquakes is the new fear of the day)- but once the rent-seekers are bought off (all the environmental movement really is) – the oil will flow and lower prices even more.

  • teapartydoc

    Hmmm. Petrostate sounds a lot like prostate. Those don’t like being squeezed either. Both can get sick that way, it seems.

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