In early 2019, Saudi Arabia revealed it is going back to modifying oil production volumes to influence crude prices. Thus, it returns to its traditional market control methodology and abandons the price war launched in 2014. What can we learn from this process that caused upheaval in the world four years ago?
By Luis Cubría Falla
The peak oil happened approximately in 2006. The phenomenon, however, did not refer to all oil, but rather conventional oil, also known as easy oil.
This conventional oil is extracted onshore or in shallow water projects. The term also refers to oil with normal viscosity or API gravity levels, not extra heavy oils that are difficult to extract.
Once the awaited peak had arrived, oil prices began a sustained rise. With the exception of the 2008 financial crisis, the Brent barrel maintained prices of over $75 practically since 2007, standing close to $110 in 2012-2014.
These high crude prices, with forecasts they would maintain over time, created two phenomena in the energy sector. On one hand, investment in renewable energies increased exponentially as they gained competitiveness compared with oil and other related commodities.
On the other hand, oil operators turned their sights to unconventional exploration and production sources, which we can divide into several types:
- Oil obtained in deep waters and extreme territories such as the Arctic.
- Oil obtained through fracking or tight oil.
- Extra heavy oil like the one extracted from Canada’s oil sands and the Orinoco Belt in Venezuela.
- Natural gas condensates.
- Biofuels obtained, for instance, from corn or sugarcane.
The United States and Russia furiously pump oil while Saudi Arabia acts as swing producer
While there are a large variety of cases, unconventional crude extraction is profitable with oil prices of over $40 or $50 per barrel.
And it was profitable. From the investments in Brazil’s Presalt and Canada’s huge open-pit mining operations to pricy fracking techniques in the United States, the unconventional sector progressively gained market share. Unconventional crude extraction also gained relevance, to the extent that worldwide oil reserves have only increased over the past 10 years.
ExxonMobil’s Outlook for Energy 2018 indicates that the conventional crude share is decreasing while unconventional sources continue to grow.
It was the days of wine and roses for the oil industry. With prices that ranged from $5 to $25 per barrel, conventional oil producers obtained huge benefits. Two major producing nations, Norway and Saudi Arabia, used their oil revenue to create multimillion public investment funds. The industry even grew in countries with a weak oil tradition, such as Colombia. In Venezuela, the chavista government found a considerable flow of dollars to finance its Bolivarian revolution. And in the United States, railways across the country were overcrowded due to the transportation of the silica sand required for fracking operations.
Everything seemed perfect until in 2014 an analyst at Saudi Aramco presented the company’s recent sales statistics to the Board of Directors. The board is comprised of a group of executives, all men – that included several westerners, former managers of the World Bank, Shell, and BG -. These men shared the table with their Arab colleagues, normally dressed in thawb and perfectly aligned with their friends and family in the government, including prestigious oil minister Ali al Naimi.
Board members confirmed, throughout several months how sales to one of the company’s biggest customers, the United States, dropped significantly, going down by 25%. In other markets, such as Asia, they stood strong thanks to the region’s dynamism and China’s relentless growth.
What happened was that the United States’ production, far from declining as had been forecasted years ago, was growing strong thanks to fracking and its tight oil and condensate production.
At that moment, the sales decline mainly focused on North America, where the industry’s tremendous strength and the financial muscle that supported fracking had managed to greatly increase production. But the Board had one doubt: could the market share loss expand to other regions?
Perhaps the time had come to curb the unconventional production rise and, by doing so, smash a fist on the table.
Up to that point, oil prices had been controlled through a supply management tactic handled through the OPEC. Oil demand is very inelastic: it is inconceivable that an oil refinery could run out of raw material, and oil producers need to sell their oil at all costs, given that they can only store a certain amount. Hence, a slight variation in production or stocks causes significant changes in the price.
And Saudi Arabia just so happens to be the nation with the greatest influence in production shifts, as it has large reserves at a low cost, a clearly positive export balance, and controls production with a single company. The role of a swing producer is a thankless one because it cedes market share in order to maintain the price and, more often than not, the rest of the OPEC producers do not strictly comply with the production cut deal.
“It is not the role of Saudi Arabia, or certain other OPEC nations, to subsidize higher cost producers by ceding market share.”
But in 2014, partly stemming from geopolitical factors such as the rising conflict in the Middle East, the fear of a quick recovery of Iranian production, and some producers’ reluctance to curbing production at such a sweet moment, the Saudis decided to do things differently. In order to effectively cut off competition from new players, Aramco drastically reduced its sales price. That is to say that it did not alter supply by ramping up production. It simply started a price war by reducing the listed price that Aramco distributed to clients. Minister Ali al Naimi said at a conference in Germany “it is not the role of Saudi Arabia, or certain other OPEC nations, to subsidize higher cost producers by ceding market share.”
And it undoubtedly succeeded in taking the price drop to the market, which went from $110 in 2014 to just $50 in 2015 and slightly over $30 in 2016.
The price drop sparked a cataclysm throughout the oil sector and particularly unconventional crude production. Large projects were halted all over the world, first in a slow and prudent manner and finally across the board. Shell canceled its extraordinary and super expensive Arctic project in northern Alaska; the Gulf of Mexico saw the interruption of the deep water projects, and the U.S. fracking sector paralyzed many of its drilling rigs, losing one thousand in just one year. The majors reviewed their program management policy and the entire sector made brutal staff reductions, dismissing more than 200,000 workers in a little over two years.
Saudi Arabia’s oil minister indicated that the country needed to manage the transition toward an economy that is less reliant on oil, but it must do so while controlling the business. The words of former colorful oil minister, Sheikh Yamani resounded once again: “the Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil.” Saudi authorities stressed the reserves funds sufficed to compensate for the lower revenue.
In 2015 and 2016, Saudi Arabia’s GDP sharply dropped, leading to a fiscal deficit in this country where 45% of the economy depended on oil. Saudi Arabia has 32 million inhabitants, no value-added tax, a large part of the population receives subsidies, and has very little industrial production of its own. The war in Yemen that started in 2015 added more fuel to the fiscal fire. That same year, the crude price needed to reach the break-even point was no less than $106 per barrel.
In June 2015, Ali al Naimi told the press in Vienna: “Our strategy is working. Demand is picking up. Good! Supply is slowing, right? I’m not stressed, I’m happy.”
Once the impact on unconventional production was achieved, prices recovered, with Brent reaching $50 in 2017 and steadily growing until late 2018.
It seemed that the price war had indeed worked. Saudi Arabia’s production was rising, exceeding 12 million barrels per day in 2016, on par with prices. But alarms went off once again by the end of 2018.
The role of swing producer is a thankless one, since it cedes market share in order to maintain the price
The U.S. fracking industry, far from being intimidated, came back with striking ferocity, lower costs, and solid industrialization of the process. The fact that many of their wells were finished and only waiting for the starting shot to begin fracking stimulation and production also contributed.
Nowadays, the United States’ production is nearing 12 million barrels of oil equivalent, clearly surpassing Saudi Arabia, and is set to reach 13 million barrels over the coming months. Russia is not far behind, pumping 11.3 million barrels per day in February 2019. This, of course, leads to a new decline in oil prices, currently at just over $60.
In addition to this, the United States has become a relevant oil exporter, already accounting for 7% of the crude supply to Europe.
Meanwhile, Arabia wonders what all this effort has led to. Perhaps because of this, just like it happened in 1986 with Sheikh Yamani, minister Ali al Naimi was replaced with Khalid al-Falih in 2016, who announced that in March of this year the nation will reduce production to 9.8 million barrels, going back to the strategy of curbing production, in collaboration with the rest of the OPEC.
This case reminds us that price wars rarely work. On this occasion, not only was a huge turnover lost but also some competitors grew stronger after adapting their production costs to a more demanding environment. This is the case of U.S. fracking, where prices can reach up to $25 per barrel.
The strategy to reduce prices was not the only failure. Saudi Arabia’s diplomatic intervention in the Syrian war was also a failure, not managing to depose Assad or ending the war in Yemen. It seems likely that the return of the oil production dance will be accompanied by the traditional checkbook diplomacy that offered such good results throughout the years.
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