America's Going to Lose the Oil Price War
The financial debacle that has befallen Russia as the price of Brent crude dropped 50 percent in the last four months has overshadowed the one that potentially awaits the U.S. shale industry in 2015. It's time to heed it, because Saudi Arabia and other major Middle Eastern oil producers are unlikely to blink and cut output, and the price is now approaching a level where U.S. production will begin shutting down.
Representatives of the leading members of the Organization of Petroleum Exporting countries have been saying for weeks they would not pump less oil no matter how low its price goes. Saudi Arabian Oil Minister Ali Al-Naimi has said even $20 per barrel wouldn't trigger a change of heart. Initial reactions in the U.S. were confident: U.S. oil producers were resilient enough; they would keep producing even at very low sale prices because the marginal cost of pumping from existing wells was even lower; OPEC would lose because its members' social safety nets depends on the oil price; and anyway, OPEC was dead.
That optimism was reminiscent of the cavalier Russian reaction at the beginning of the price slide: In October, Russian President Vladimir Putin said "none of the serious players" was interested in an oil price below $80. This complacency has taken Russia to the brink: On Friday, Fitch downgraded its credit rating to a notch above junk, and it'll probably go lower as the ruble continues to devalue in line with the oil slump.
It's generally a bad idea to act cocky in a price war. By definition, everybody is going to get hurt, and any victory can only be relative. The winner is he who can take the most pain. My tentative bet so far is on the Saudis -- and, though it might seem counterintuitive, the Russians.
For now, the only sign that U.S. crude oil production may shrink is the falling number of operational oil rigs in the U.S. It was down to 1750 last week, 61 less than the week before and four less than a year ago. Oil output, however, is still at a record level. In the week that ended on Jan. 2, when the number of rigs also dropped, it reached 9.13 million barrels a day, a 44-year high. Oil companies are only stopping production at their worst wells, which only produce a few barrels a day -- at current prices, those wells aren’t worth the lease payments on the equipment. Since nobody is cutting production, the price keeps going down; today, Brent was at $48.27 per barrel and trends are still heading downward.
All this will eventually have an impact. According to a fresh analysis by Wood Mackenzie, "a Brent price of $40 a barrel or below would see producers shutting-in production at a level where there is a significant reduction in global oil supply. At $40 Brent, 1.5 million barrels per day is cash negative with the largest contribution coming from several oil sands projects in Canada, followed by the U.S.A. and then Colombia."
That doesn't mean that once Brent hits $40 -- and that is the level Goldman Sachs now expects, after giving up on its forecast that OPEC would blink -- shale production will automatically drop by 1.5 million barrels per day. Many U.S. frackers will keep pumping at a loss because they have debts to service: about $200 billion in total debt, comparable to the financing needs of Russia's state energy companies.
The problem for U.S. frackers is that it's impossible to refinance those debts if you're bleeding cash. At some point, if prices stay low, the most leveraged of the companies will go belly up, and the more successful ones won't be able to take them over because they will have neither the cash nor the investor confidence that would help them secure debt financing.
The insolvencies and lack of expansion will finally lead to output cuts. The U.S. Energy Information Administration still predicts that U.S. crude production will average 9.3 million barrels a day, 700,000 barrels a day more than in 2014. But if Brent goes to $40, that forecast goes out the window. It's probably overoptimistic even now.
As for the Saudis and the United Arab Emirates, they will just keep pumping. They are countries, not businesses, and they cannot just close down shop and go home -- they still have budgets to finance and no replacement for oil as a source of international reserves. Russia, the world's third biggest oil producer after the U.S. and Saudi Arabia, is much shakier than the Middle Eastern oil monarchies, but it's in the same situation: Oil is its lifeblood.
This could be a bloody, prolonged battle with an uncertain outcome. Oil supply and demand are rather inelastic to the price in the short term. The price's trajectory this year will, therefore, be largely dictated by the news and the market's reaction to it. A wave of bankruptcies in the U.S. shale industry will probably drive it up because it will be perceived as a negative factor for supply. How high it will go, however, is unpredictable. It may actually rise enough to enable consolidation in the U.S. shale industry, giving it second wind and driving OPEC countries, Russia, Mexico and Norway into greater difficulties -- or it might just even out at a level that would make the U.S. forget about its shale boom. That would have dire consequences for the U.S. economic recovery.
It may be time for the U.S. government to consider whether it wants to up the stakes in this price war by entering it as a sovereign country. That might mean bailing out or temporarily subsidizing the shale producers. After all, they are competing with states now, not with businesses like themselves.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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