Saudi Arabia's Risky Oil-Price Play
With the U.S. on track to become the world’s largest oil producer by next year, it’s become popular in Washington and on Wall Street to call America the new Saudi Arabia. Yet the real Saudi Arabia hasn’t relinquished its role as the producer with the most influence over oil prices. Its reserves of 266 billion barrels, ability to pump as many as 12.5 million barrels a day, and, most important, its low cost of extracting crude still make it a formidable rival to the U.S., whose shale wells are hard to exploit. “Saudi Arabia is the only one in the position of putting more oil on the market when they want to and cutting production when they want to,” says Edward Chow, a senior fellow at the Center for Strategic and International Studies in Washington. The Saudis are also the most powerful member of OPEC, the 12-member group that’s increasingly facing off against Russian, U.S., and Canadian production.
In September, despite a global oil glut developing largely because of China’s slowdown and the rapid increase in U.S. production, the Saudis boosted production half a percent, to 9.6 million barrels a day, lifting OPEC’s combined production to an 11-month high of almost 31 million barrels a day. Then, on Oct. 1, Saudi Arabia lowered prices by increasing the discount it offered its major Asian customers. The kingdom might just as easily have cut production to defend higher prices. Instead, the Saudis sent a strong signal that they were determined to protect their market share, especially in India and China, against Russian, Latin American, and African rivals. Iraq and Iran followed Saudi Arabia’s example.
The news set off a bear market in oil: Brent crude, the international benchmark, fell from $115.71 a barrel on June 19 to $82.60 a barrel on Oct. 16, the lowest price in almost four years, as investors realized that the big oil states were not going to cut production. “OPEC appears to be gearing up for a price war,” Eugen Weinberg, head of commodities research at Commerzbank, wrote on Oct. 2. The Saudi government wouldn’t comment for this story.
Oil exports account for 85 percent of the Saudi government’s revenue, and the International Monetary Fund estimates the kingdom needs an annual average price of at least $83.60 a barrel to balance the national budget: The average for Brent crude this year is $106, still above the Saudi break-even price.
A foreign diplomat based in Riyadh suggests that while the Saudis are most comfortable with $100-a-barrel oil, current prices are no cause for alarm because of their strong fiscal position. The diplomat adds that one reason Saudi Arabia cut prices was its awareness that global economic growth is fragile and that cheaper crude could help its customers grow faster. Every 10 percent drop in oil prices spurs 0.15 percent more consumption in the global economy. That consumption sets up additional demand of almost 500,000 barrels of oil a day, Goldman Sachs estimates. Oil that’s 20 percent cheaper than the average price of the past three years amounts to a $1.1 trillion annual stimulus to the world economy, Citigroup says. The diplomat asked not to be identified because his embassy doesn’t want to comment publicly on Saudi oil policy.
The kingdom has sterling credit and about $735 billion in financial reserves, so it’s better positioned to withstand a prolonged downturn than its rivals, says Bruce Jones, a senior fellow at the Brookings Institution in Washington. A price war could do serious damage to nations already on the ropes. Iran, whose exports are still constrained by Western sanctions, needs $153.40 a barrel to break even, according to the IMF. “Knowing that Iran is going to struggle, that’s something Saudi Arabia would certainly enjoy,” says Reva Bhalla, vice president for global analysis at Stratfor, which advises companies on political risk. Russia counts on $100 a barrel: Its budget loses about $2 billion for every dollar drop below that price, says Maxim Oreshkin, head of strategic planning at Russia’s Finance Ministry.
An unanswered question is whether sustained lower prices will hurt the U.S. shale boom. Busting oil out of miles-deep shale using hydraulic fracturing and sideways drilling costs $50 to $100 a barrel, says the International Energy Agency, vs. pumping costs of $10 to $25 a barrel in the Mideast and North Africa. The point at which shale drilling turns broadly unprofitable is debated by analysts. The IEA says only 4 percent of U.S. shale oil production needs prices above $80 a barrel; Sanford C. Bernstein analysts put it around one-third. Shale oil accounts for 55 percent of U.S. production.
Shale wells deplete faster than conventional ones, so U.S. drillers have to find enough new shale oil deposits to replace the 1.8 million barrels a day that exhausted wells no longer produce. And that’s just to keep annual production flat, says Vikas Dwivedi, oil and gas economist for Macquarie Group. The diplomat in Riyadh doubts the Saudis have a deliberate policy of blunting unconventional oil production such as fracking. It wouldn’t make sense to injure the U.S., an ally in the war against Islamic State.
The Saudi policy of waging a price war has already hurt weaker members of OPEC. Venezuela has called for an emergency OPEC meeting to organize price hikes. The Venezuelans’ request was ignored by Saudi Arabia and Gulf ally Kuwait: They say they don’t intend to change course before the next OPEC meeting on Nov. 27.