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Crude Economics
Saudis Set Up Showdown With Shale

Saudi Arabia cut the price at which it sells crude to U.S. refineries earlier this week, in a move that many saw as an attempt to put the brakes on the American shale boom and gain market share. The NYT reports:

The effort was interpreted by many traders as a sign that Saudi Arabia will try to compete with American oil to protect its shrinking but still considerable market share in the United States…Production in the United States increased by 70 percent over the last six years, reducing OPEC imports by roughly a half.

We’re seeing a high stakes game of chicken, with the Saudis and OPEC betting on the likelihood that American shale producers will feel the pinch of sustained low crude prices before the cartel’s petro-states do. The breakeven prices vary between American shale formations significantly, just as they do between the various members of OPEC. OPEC needs a high price for members to balance their budgets, while the shale revolution needs a high price to continue drilling profitably. By neglecting to cut production as they’ve done in the past, OPEC is consigning itself to lower prices and unbalanced budgets in the short-term, while expecting U.S. shale producers to reduce output and eventually stabilize the market.

There’s one potentially fatal flaw in that plan, however: American innovation. U.S. drillers continue to improve on the techniques that let them unlock shale in the first place, and the breakeven prices for various formations are dropping accordingly. If the U.S. continues fracking as usual, the world could have a massive oversupply of crude next year, as the FT reports:

Opec expects the US shale industry to swerve first, cutting its production. If he is wrong, and Opec too refuses to cut its production, the world could be heavily oversupplied with oil next year, especially if global growth remains sluggish. Prices would slump even further.

Cheaper oil prices are generally good for economies, unless those economies rely on the profits they make from oil and gas sales. With American shale production getting ever more efficient, it’s looking like OPEC and the rest of the world’s petrostates (looking at you, Russia) have a lot more to lose if prices keep plunging.

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  • S.C. Schwarz

    This strategy can’t work. Since Saudi Arabia’s marginal cost is low, yes, the they can flood the market and drive down the price. This will cause some marginal producers to reduce production or quit. The Saudi’s will then have a larger market share at a dramatically lower price. We get cheaper oil and what do they get? And if they try to boost the price later, the marginal producers just come back.

    The Saudi’s are quite smart enough to realize all this. The reason the are driving down the price of oil is that it hurts their enemies (Iran, and to a lesser extent Russia.) more than it hurts them.

    • John B Gorentz

      I question whether they are motivated by the need to hurt their enemies, but am willing to learn otherwise if you can point me to it. Saudi Arabia has had to do this before, and it’s usually explained as a need to maintain their revenues.

    • Brett Champion

      That might be true, but it would partially depend on what the cost of shuttering and restarting production would be for the shale-oil producers. And even if the cost is not prohibitive, they might still keep the production shuttered when prices rise if they believe the Saudis would just simply bring the price down again.

      • George Armstrong Custer

        One should note that almost all of the leases in the large shale oil formations in the US do not require the drillers to keep on drilling when it is not economical to do so. Lease holders can stop drilling and then resume once it becomes economical.
        There is a new paradigm in the energy business and the Saudis are doomed to failure.

    • rheddles

      The Sauds have realized that neither the US nor Israel will take effective action to prevent Persia Iran from developing nuclear weapons. (Though whether they can is becoming questionable after decades of effort. It took the US only two years to do so when it had never been done before. Iran didn’t have to do that much research, just development. And thus far they’ve been incapable of delivering the big boom.)

      At any rate, the Sauds have the most to lose from a Iranian/Shia ascendency, as in everything. We’ll know that the target of the oil price move was Iran if the funding to Sunni troops fighting the Shia in Syria and Iraq increases. The combat between these two forces looks to become more and more vicious as one or the other comes close to victory, cf the Iran-Iraq war. The worst place for the US to be is in between them. We should be supporting whomever is losing. It’s a shame they can’t both lose.

  • maulerman

    As to the break even costs and how all shale formations are not created equal, it is very important to understand that shale production is typically three components, oil, natural gas and natural gas liquids. These three commodities do not move in sync with their BTU content anymore. Therefore, shale wells which produce significant volumes of natural gas, such as the Eagle Ford trend in Texas, will still have strong economics if natural gas prices stay up even if oil prices are down.

    • John B Gorentz

      Do you know of easily accessible information about which regions produce which proportions of the three components — in very general terms? I’m just looking for a big picture – not trying to feed quantitative models or anything.

  • Andrew Allison

    It may be simplistic to think that the Saudis reduced the price of oil sold in the US to make fracking less attractive. It could simply be an acknowledgement that shale oil has put a lid on oil prices in the US.

  • Jacksonian_Libertarian

    At the moment Saudi Arabia needs $94 per barrel to balance its budget, so with $80 per barrel prices it is already dipping into its savings of $600 Billion by about $50 billion over a year’s time, and prices look to go much lower. American Shale Oil producers have been cutting their production costs by about $10 per barrel every year like clock work, eventually this will end but for the moment the trend really is our friend. American Shale Oil producers are also not saddled with being monopolies owned by a Government Monopoly. Can you imagine the incompetence, waste, and corruption in a monopoly owned by a monopoly? Costs have been rising for all the OPEC and other Government Monopoly owned Oil companies, which is just the reverse of what is needed to compete in the oil fungible global market. Here the American Shale Oil producers have already shown their skill and expertise at competing in a free market, where others demonstrate nothing but failure. All monopolies suffer from the same disease, the lack of the “Feedback of Competition” which forces continuous improvements in Quality, Service, and Price in free markets.

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