Saudi Arabia’s oil minister this week made it brutally clear why the Saudi-led OPEC chose to maintain production in the face of plummeting oil prices. It was a strategy, he said, not just in response to the plunge in the price but for the future.
The rise of US shale production -- US oil production is up 70 per cent in six years and has halved US oil imports -- has transformed the supply-side of the oil and gas sector. It has also undermined OPEC’s dominance of its pricing, with powerful economic and geopolitical consequences.
The Saudi stance, therefore, is designed not just to maximise its volumes in the facing of prices that have almost halved in a little over six months but to create more permanent, structural changes to the industry’s supply-side by driving out higher-cost production.
In many respects it is the same story that is playing out across the resource sector, most visibly in iron ore where the decisions by Rio Tinto and BHP Billiton to continue to expand production into an already over-supplied market have been controversial and have helped force the price to five-year lows.
As the low-cost producers, theirs’ is a rational strategy, offsetting the losses of margin with increased volumes. Whether it is an objective of their strategies, or a side-effect, the impact of their increased out-put on a market already in surplus is, in the absence of an unlikely rebound in China’s demand, going to decimate higher-cost producers and return them to a position of dominance of the seaborne trade.
Saudi Arabia’s Ali al-Naimi provided an insight into OPEC’s thinking in a series of quite candid interviews this week.
It wasn’t in OPEC's interest to cut production to lift prices, he said.
"Whether it does down to $US20 a barrel, $US40 a barrel, $US50 a barrel, $US60 a barrel, it is irrelevant," he said.
It was obvious from experience that non-OPEC producers like Russia wouldn’t reduce production in response to the lower prices.
"Is it reasonable for a highly-efficient producer to reduce output while the producer of poor efficiency continues to produce? That is crooked logic. If I reduce, what happens to my market share? The price will go up and the Russians, the Brazilians, US shale oil producers will take my share," al-Naimi told the Financial Times.
It is difficult to argue with that analysis, which applies to most of the commodity markets. If the low-cost producer (and the Saudis are the low-cost producers) reduces its production in response the lower prices, it is effectively gifting market share and revenue to less efficient producers. A rational strategy would be for the Saudis to increase production and the pressure on higher-cost producers.
The most obvious casualty of the OPEC strategy so far has been Russia, which has been plunged into an economic crisis given that oil and gas generates half the Russian Government’s revenue. A heavily indebted Venezuela, Nigeria, Iran and Canadian oil sands producers are also under pressure.
The big question, however, and the one that might decide the success or failure of OPEC’s attempt to regain its position of dominance of pricing is the impact of sub-$US60 a barrel West Texas Intermediate prices on the US shale sector.
There is a massive debate occurring in the US about the extent to which US production could be affected. The analysis is confused by the reality that the economics of the various shale basins in the US vary quite markedly. Some basins will still be profitable at $US40 a barrel while others would be uneconomic at $US80 a barrel.
Another layer of complication is that at the more junior end of the sector there is a lot of debt. About 17 per cent (or more than $US200 billion) of the US junk bond market represents funding to energy companies, which explains why there has been a major sell off within that market.
The extent to which that might blow up a significant proportion of the US shale gas sector depends, not just on whether oil prices remain at low levels or even fall further, but on the maturity patterns for that debt and also the extent to which the producers have hedged out their production at higher prices.
The continuing improvement in productivity within the sector as it has gained more experience and access to big company technology and processes also means production costs and timeframes have been rapidly improving. Lower prices will impose even greater cost discipline.
There is a view among analysts of the sector that the US will prove more resilient than OPEC expects but also that it will prove more flexible, with some production shut down temporarily only to start up again if prices firm.
That would place a cap on prices and on the extent to which OPEC could take market share from the US and would see the US take over Saudi Arabia’s role as the world’s swing producer.
While Saudi Arabia and some of its fellow OPEC members can withstand a period of low prices, given their vast accumulated investment portfolios, none of them can fund their current government spending at today’s oil prices. They’ll either have to cut spending or begin depleting their reserves.
With OPEC now representing less than 40 per cent of the world’s oil production the traditional response to lower prices -- production cuts -- would hurt only OPEC members unless they could somehow convince the rest of the world to cut output in tandem with them, which is almost inconceivable and which therefore represents the foundation of al-Naimi’s thinking and OPEC’s strategy.
What tends to be lost in the discussion about OPEC’s action or inaction is that it is designed to eventually lead to higher oil prices by knocking out some of the supply. In the medium to longer term, that will also benefit those non-OPEC oil and gas producers who can adapt to or simply survive a sustained period of low prices.