The Saudis' battle with US shale is far from over

The Saudis believe their tactics have resulted in some stability for the oil price, but there are question marks over how effective their strategy will be in the long run.

After a dramatic 60 per cent plunge in oil prices, something approaching stability within the market may be within reach, with Saudi officials providing signals that they may have achieved their objectives.

The collapse in oil prices, from a high of about $US115 a barrel last year to below $US50 a barrel, was precipitated and exacerbated by the Saudi-led OPEC decision to maintain production in the face of an emerging glut of supply. That excessive supply at least partly driven by the rapid development of the US shale oil and gas industry.

The Saudis made no bones about their core objective in deciding not to play their traditional role as the swing producer and cut production to maintain prices.

They wanted to knock out higher-cost production, with the obvious target the US industry which, after increasing US oil production by about a third in four years, was undermining OPEC’s influence over the market and altering long-held geopolitical norms.

It now appears that, rather than just maintaining their production, the Saudis actually increased supply even as the price began tumbling, with the chief executive of the state-owned Saudi Aramco telling a conference in the kingdom this week that the Saudis were now producing about 9.8 million barrels of oil a day -- about 300,000 barrels more than previously publicly acknowledged.

The combination of that increase output and the still-rising (but presumably soon to be falling) output in the US has undoubtedly been a major influence over the speed and extent of the plunge in oil prices.

US shale oil wells deplete rapidly, and producers have to keep drilling new wells to maintain or increase their output. So, while production has been rising even as the number of rigs actually drilling has been falling, it won’t take long for the massive cutbacks in activity to show up in lower production.

It isn’t just the US shale oil sector that has been hit hard by the plummeting prices. The International Energy Agency forecast last week that investment in oil production would fall by about 15 per cent, or $US100 billion this year. Around the world almost all of the major oil and gas producers are scrambling to cut back on their spending and to reduce costs.

OPEC’s secretary-general Abdalla El-Badri told the Middle East conference that the sharp decline in investment could eventually lead to $US200 a barrel oil. According to the Financial Times, he also said that ‘’maybe prices have reached a bottom’’ and that he was sure that prices would eventually rebound while reaffirming OPEC’s commitment to maintaining market share.

While Russia, Venezuela, Nigeria, Mexico, Canada and other oil-producing countries have been badly damaged by the tactics of the Saudis, if the real target was the US, there is a question mark over both where the oil price might eventually settle and how effective the strategy might be in the long run.

That’s because the US shale gas sector is quite immature and is on a steep learning curve. It was instructive that when BHP Billiton announced it would cut the number of rigs it has deployed in the US from 26 to 16 by June, it didn’t change its shale oil production target.

The technology and processes for extracting shale oil have been improving both rapidly and significantly and as the productivity of the sector has improved, break-even levels have been tumbling.

The nature of the industry also means that production, unlike most conventional oil resources, can be cut back and then turned on quite quickly. A new well can be drilled within a week and at a cost of about $US1.5 million, which is reducing and which fell nearly 20 per cent on average last year.

Thus, if the Saudis and OPEC want to permanently limit the impact of US shale gas on the global market for oil, they will need to ensure the price remains below the levels which would bring the dormant reserves back into the market.

It would seem, given the commentary coming out of the conference in the Middle East, that they believe prices around the $US50 a barrel or just below are achieving their objectives in reducing supply from the sources they were targeting.

If sustained for any reasonable length of time, that will remove the glut of supply without OPEC itself having to reduce production.

Over the longer term, however, as the massive cut-backs in investment in new and marginal production flow through and interact with still-rising demand, the price will rise and bring back some of the latent resources sidelined at current price levels.

While that might make $US200 a barrel oil a remote possibility, it would suggest that the current price levels are a reasonably temporary phenomenon and that the OPEC producers, once the current glut has been worked through, will try to engineer a price level that enables them to maximise or at least maintain their market share of a growing market.

If the US shale gas sector has replaced Saudi Arabia as the world’s swing producer, that probably means a price around the levels at which the lower-cost US producers can generate reasonable returns on capital.

That’s significantly lower than the $US100-plus a barrel levels to which the price soared last year and a level that is still falling as shale oil production experience and productivity continues to improve.