Saudis Are Winning the War on Shale
If you believe all the recent stories about how Saudi Arabia is losing the price war it started against U.S. tight oil producers last year, the new Oil Market Report from the International Energy Agency offers a reality check. The Saudis are winning, though they're paying a heavy price for it.
The narrative about U.S. shale's resilience in the face of the Saudi decision to drive up production, prices be damned, centers on the American industry's ability to cut costs and use innovative technology to repel the brute force onslaught. There is a kind of David versus Goliath charm to this story, but the data don't bear it out. The IEA, the world's most respected independent source of information about the oil market, has changed its methodology for measuring U.S. output: It now polls producers, instead of relying on data from states. And the switch has caused the agency to revise production data for the first half of 2015, showing a noticeable slowdown.
The U.S. is still pumping more than it did last year, but the output is declining:
IEA data show monthly contractions of 90,000 barrels a day in July and almost 200,000 barrels a day in August. Output is dropping for all seven of the biggest U.S. shale plays. The IEA predicts that the U.S. production of light tight oil -- the type pumped by frackers -- will go down by 400,000 barrels a day next year, about as much as Libya currently produces. That drop will account for most of the 500,000 barrels a day drop in production outside the Organization of Petroleum Exporting Countries that the agency predicts for 2016. Production is also dropping in Canada: It's below 4 million barrels a day for the first time in 20 months.
The IEA doesn't believe shale oilers' incantations about drastically lower marginal cost of producing oil from already drilled wells. It points out that tight oil wells dry up much faster than traditional ones: Recent data show that output drops 72 percent within 12 months of startup and 82 percent in the first two years of operation. "To grow or even to sustain production levels requires continuous investment," the IEA report says. Low oil prices reduce frackers' access to the capital they need, and rig counts are falling again -- in early September the drop was the steepest since May.
The number of active rigs has fallen by 40 percent from a year ago. They are far more productive, because they are only being used in the most profitable locations, but that tactic has largely exhausted itself. A steeper production decline cannot be staved off for much longer.
None of this should come as a surprise. If there is one thing the Saudis know about, it's oil. They know all about the new technology used by U.S. shale, too: They work with the same international service companies and attend the same conferences. They did not make a dumb mistake gambling with their only economic advantage. The IEA reported: "On the face of it, the Saudi-led OPEC strategy to defend market share regardless of price appears to be having the intended effect of driving out costly, 'inefficient' production."
The perception that Saudi Arabia is losing the oil war is based on the absence of a spectacular rout in the U.S. -- the shale industry hasn't collapsed, right? -- as well as the Saudis' own fiscal difficulties. The kingdom is certainly running through its foreign currency reserves faster than shale oil output is falling:
So what, price wars are costly. And victory in them doesn't usually mean the complete destruction of the losing side. Rather, the Saudis seek submission.
The IEA notes an increase in demand for oil at the current low prices. Much of that increase is in developed countries, including the U.S., where people are more willing to take long drives now gasoline is cheaper. It will be the Saudis, pumping at near record levels, who meet this extra demand -- not U.S. frackers. OPEC has 2.27 million barrels a day of spare capacity, with 86 percent of that in Saudi Arabia's hands.
The Saudis are teaching the market that they are the go-to suppliers at any price level and that they're always going to be there, unlike those fly-by-night American operators. They're also teaching investors in U.S. shale that as soon as they plow more money into the sector, they, the Saudis, will boost output and drive prices lower, ruining the economic models on which the investment decision was based. That's a lesson they want to sink in, because there's still a lot of talk about shale's nimbleness in responding to changing price conditions.
Leaving purely financial speculation aside, oil prices cannot go up for any extended period while the Saudis are teaching their oil class to the frackers. So long as the U.S. shale industry reacts to price rises with production increases, prices will keep falling back. They will stabilize at a level acceptable to petrostates only once that response becomes muted. No victory announcement will be needed: Things will just look peaceful again.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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