U.S. shale producers should benefit enormously when the Organization of Petroleum Exporting Countries (OPEC) and Russia start cutting back on oil production in January, writes Ignatius Chithelen in this opinion piece. Chithelen manages Banyan Tree Capital in New York City and is the author of Six Degrees of Education. Neither Banyan nor he has any investments in crude oil.
Since the first oil price shock of 1973 Saudi Arabia has been a key player involved in boosting or lowering crude oil prices, by cutting or raising global supplies, a role formalized by its dominance of the Organization of Petroleum Exporting Countries (OPEC). In the past few years, though, rapidly rising production of crude oil from shale deposits in the U.S. has diminished the impact of Saudi Arabia’s actions. It is the U.S., not Saudi Arabia, which is now the effective global swing producer, though America does not play that role in the same way that Saudi Arabia did.
Privately owned companies, which produce oil in the U.S., raise and lower production based on profits and losses and not on the political dictates of the government, as happens in Saudi Arabia and Russia, the leading non-OPEC oil producer.
U.S. oil and petroleum liquids production nearly doubled from 8.5 million barrels a day (mb/d) in 2007, before the last recession, to 15.1 mb/d in 2015, with the bulk of the gains coming since 2011. Over the same period the output of the OPEC countries stayed flat at around 38 mb/d. The rise in U.S. output was due to new technologies such as horizontal drilling and fracking, which unlocked oil and liquids – as well as natural gas — from shale deposits.
It was also fueled by the tripling of oil prices from some $40 a barrel in 2007 to around $120 a barrel in 2011 and due to prices staying around $100 until mid-2014. Hundreds of existing and new energy companies in the U.S. got billions of dollars in funding from investors seeking to profit from the shale boom.
“There is potential for substantial growth in U.S. output even if prices stay around the current level of $52 a barrel.”
On December 10, under the leadership of Saudi Arabia, the non-OPEC countries, chiefly Russia, formally agreed to cut output by 558,000 barrels a day. The OPEC countries had earlier agreed to cut output by 1.2 mb/d, if Russia decided to participate. Global supply is currently 96.2 mb/d, with a third coming from OPEC countries and an additional 18% from non-OPEC countries that have agreed to cuts. Global demand, whose growth is tied to GDP growth, is about 95.4 mb/d.
The 1.8 mb/d in total cuts by the OPEC and non-OPEC producers represent about 2% of global supplies. The Saudis and the other production cutters reckon that such a drop in supply will lead to higher prices, given that the supply demand gap is fairly tight.
In the past OPEC members, including major producers like Venezuela and Iran, and major non-OPEC producers Russia and Mexico either did not cut output at all or not to the full extent of their quota. Some even raised output higher than what they were producing before the agreement. This time around most major producers may be unable to produce over their current output, even if they want to benefit from higher prices, since their run down fields require large amounts of capital investments.
What Will Russia Do?
It remains to be seen if Russia, which produces about 11 mb/d, will cut its output by 300,000 barrels a day and meet its commitment. Also, while Iraq was denied an exemption from cuts by OPEC, Libya and Nigeria were granted exemptions on the grounds that their output is already below their normal production. So it is not known whether or not Iraq will cut output.
At times in the past, the Saudis ignored cheating by the others and expanded their cuts to support higher prices. Recent news reports say that the Saudis are so eager to boost oil prices that they may cut more than their quota of about 600,000 barrels a day.
Assuming the cuts do occur, U.S. producers will be a major beneficiary of higher prices. In anticipation of the cuts that are to begin on January 1, 2017, prices have risen by some 20% in the past month to a recent $52 for a barrel of West Texas Intermediate (WTI), the benchmark for crude oil in the U.S. The response from the U.S. producers was quick — 27 more land rigs began operating in the U.S. in the week ended December 9, for a total of 601 rigs.
The rise in oil prices will likely be capped at around the current level, though there may be short-term spikes due to supply disruptions and conflicts in the Middle East. At around $60 a lot more oil will start flowing from shale production in the U.S., perhaps adding enough new supply to more than make up for any cuts by the OPEC and non-OPEC countries. The technology and the production efficiencies in the U.S. have continued to improve, triggered in large part by the collapse of oil prices from $108 in June 2014 to $29 in January 2016.
The Saudi Factor
In mid-2014 Saudi Arabia expanded production ostensibly to try to curb further growth of shale production in the U.S and protect its market share. The recent Saudi-led cut in output implies that it is no longer seeking to restrict U.S. shale production. Also it appears odd that a leading producer seeks to protect market share instead of striving to be the low-cost producer in a commodity business.
In 2014 some analysts argued that the Saudis raised output under pressure from the U.S. Administration, which wanted to use the most effective way to punish Russia for annexing Crimea and other parts of Ukraine – cutting oil prices and thus choking Russia’s main source of revenue.
“Additional incentives are likely to be given to the oil industry to further reduce dependency on imports and encourage exports.”
Saudi Arabia currently produces about 10.2 mb/d and its spare capacity is estimated to be an additional 2.3 mb/d. It has proven reserves of about 261 billion barrels and so can potentially raise its output sharply. But it faces capital constraints. Revenues from crude oil are the main source of funding for the government, which provides most of the jobs in the Kingdom as well as giving major subsidies to its population.
Now, like the U.S. oil companies, the Saudi government is seeking to fund its growth plans through the capital markets. Saudi Aramco, the national oil company run by the government, is reported to be planning to raise $100 billion in the largest initial public offering expected in 2018. The Saudis decision to lead the cut in output and try to move oil prices higher may also have been motivated by the desire to boost Aramco’s margins and have a successful IPO.
The U.S. imports about five mb/d of oil to meet its total consumption of about 20 m/bd. The Trump Administration taking office in 2017 has said they will lift regulations, lower taxes and offer incentives to businesses to create domestic jobs. Additional incentives are likely to be given to the oil industry to further reduce dependency on imports and encourage exports. Rick Perry, the former Governor of Texas and a supporter of unfettered growth of the U.S. energy industry, has been nominated to be the Secretary of Energy. There is hence potential for substantial growth in U.S. output even if prices stay around the current level of $52 a barrel.
Scott Sheffield, the CEO of Pioneer Resources, has said that the company’s operating costs per barrel in the Permian Basin in Texas is $2 – the same as in Saudi Arabian oilfields – and its breakeven costs are under $30 a barrel. The basin is the most productive and low cost shale field in the U.S. and is estimated to have reserves that will last for the next 100 years. Pioneer, a well-managed public company with an enterprise value of $33 billion, is one of the companies focused on profiting from the shale boom.