Could Saudi Arabia crash the US shale oil boom with a price war?

Could Saudi Arabia crash the US shale oil boom with a price war?.

 

Author’s note: This is the second installment of a series. View Part 1 hereView Part 3 here.

The recent decision by the Saudi Arabian government to slash the price at which it sells oil to the US has raised concerns that lowering oil prices could crash the US fracking boom.

There is a lot at stake for the US economy in the shale oil boom for as long as renewable energy has not come into the mainstream. Energy security and the potential stimulating impact of the shale oil boom on the US economy through increased business and employment are vital issues.

The development of hydraulic fracturing technology and its implications to the global oil market in terms of the sudden increase in supply caught the major oil producing countries unprepared. This leads to a tendency for the top oil producers, such as Saudi Arabia, to respond with panic measures.

A move by the Saudis and their Gulf allies to cut oil prices has the potentials to make shale oil production unprofitable. If oil prices can’t cover production costs, operations will be forced to shut down. The resulting loss of jobs and reduced spending in the oil sector, coupled with the likely eventual rebound of oil prices, could send damaging ripples through the US economy.

Some analysts have estimated the average breakeven price of US shale operations at $76-77 a barrel, while Goldman Sachs recently quoted an estimate of $75. This implies that if the Saudis lower price to about $75 some US shale operations could find themselves operating at a loss.

However, a new report by Investment bank Citi analysts titled, “The Rapid Rise of the US as a Global Energy Superpower,” argues that oil prices would have to fall as low as $50 to halt US production entirely.

It is unlikely that oil prices fall that low.

The report estimates full-cycle costs for shale production as falling in the range $70-80. According to the Citi analysis, if prices fall to about $70 it will slow down shale production severely but will not halt it entirely.

But an all-out price war to undercut shale production would also have serious damaging impact on the economies of Saudi Arabia, its Gulf state allies and OPEC countries in general. Thus, the Saudis can lower prices only under severe constraints that improve the chances that US shale oil producers will be able to sustain the price-war standoff. They hope that the Saudis, feeling the damaging impact on their economies in the medium-term, would be forced to abandon the strategy.

As Citi analysts note, the US economy would likely be able to weather the storm of any onslaught the Saudis could likely unleash because while falling crude oil prices would slow down shale production, it will also cause a fall in gas prices which tend to have a boosting impact on the economy.

Average national gas prices have already fallen below $3 for the first time in about four years.

But assessment of the boosting impact of falling gas prices hinges on how US consumer spending responds. In a situation where lack of confidence in the US economy is due, for instance, to a political gridlock in Washington, dampens consumer confidence, the fall in gas prices may not be able to exert its full potential boosting impact.

The risk of heavy backlash on the Saudis has caused many analysts to question the effectiveness of a price war strategy to rein in shale production. The conviction that expansion of shale oil production is inevitable, especially in the situation where other major oil and gas producing countries, such as Russia, are also poised to begin shale exploration leads to questioning the view that the recent lowering of oil prices by the Saudis was targeted primarily at US shale oil boom.

It seems correct at this point to conclude that increasing challenges to Saudi and OPEC market shares from the US shale oil boom is inevitable. The threat will likely intensify as shale oil production costs decrease due to improvements in technology.

Strategies that OPEC countries have used effectively in the past to maintain tight control over global oil market, such as cutting production to shore up oil prices or dropping oil prices to curb North Sea oil production, will become less and less effective as shale oil boom impacts on the global energy supply.

Control of the global oil market by the Saudis and OPEC will likely weaken in the next few years.

A price war will hurt the economies of OPEC countries

A Saudi-led price war to curb US shale oil production will threaten the political and economic stability of many OPEC member states. Thus, a decision by the Saudis to go ahead with a price war strategy would likely cause a rift in OPEC.

Many of the OPEC members would prefer a cut in production to push oil prices up. Some OPEC members led by Venezuela are already clamoring for a cut in output to push oil prices back to about $100 a barrel. The fact is that there are simply too many OPEC countries much more vulnerable than the wealthy Saudis to a fall in oil prices.

According to Reuters, Venezuela, one of the most vulnerable OPEC countries, is resisting the Saudi move to lower oil prices. The country’s foreign minister Rafael Ramirez, recently protested against the Saudi move, saying, “It doesn’t suit anyone to have a price war, for the price to fall below $100 a barrel.”

According to analyst Pepe Escobar in an interview with Russia Today, countries such as Venezuela and Ecuador, Iran and Iraq, need oil prices to remain over $100 a barrel.

Other major OPEC countries such as Nigeria are also very vulnerable and need good oil prices to balance their budgets to avoid running deficits. Nigeria’s situation is complicated by an ongoing war in its northeastern region. The festering insurgency in northern Nigeria is further complicated by regional geopolitics of oil as well as issues of internal politics.

The Central Bank of Nigeria announced recently that it was restricting the sale of dollars in the regulated foreign exchange market to prevent a sharp fall in the value of the naira which is under pressure due to falling oil prices.

According to the statement by the bank, the move was necessary “to maintain the existing stability in the foreign exchange market.”

Image: US Secretary of State John Kerry with King Abdullah bin Abdulaziz Al Saud of Saudi Arabia, January 2014. http://commons.wikimedia.org/wiki/File:Kerry_and_Abdullah,_2014.jpg