Saudi Arabia and the rest of OPEC may regret their decison to cut production, as this has led to a resurgence in US shale-oil production – and a further wave of innovation in shale technologies. Combine this with a slowdown in the Chinese economy and oil prices could be at $35/bbl or less by Q4 2017
By John Richardson
SAUDI Arabia might have made a costly mistake by abandoning its market share strategy in favour of what could be a failed bid to drive prices to around $60/bbl by the end of this year.
The market share strategy – pursued by former Saudi oil minister Ali Al-Naimi from 2014 until November of last year – had taken considerable wind out of the shale oil industry’s sails. The number of active rigs fell as oil prices declined, with several US shale-oil players forced to enter Chapter 11. As Bloomberg writes:
Since the beginning of 2015, 123 North American oil companies with almost $80 billion of debt filed for bankruptcy. Between June 2015 and July 2016, US oil production shrank 12%.
But then Al-Naimi retired in May 2016 and was replaced by the current Saudi oil minister, Khalid Al-Falih, who almost immediately signalled a U-turn. From November of last year we then saw production cutbacks involving both OPEC and non-OPEC producers.
The end-result has been $20bn of private equity pouring into the US shale industry in Q1. Major oil companies have also invested more in shale, with ExxonMobil spending $5.6bn in February alone.
As the chart at the beginning of this blog post indicates – from Baker Hughes – the number of US rigs in operation is therefore on the rise again. OPEC has cut production by 500,000 bbls/day since last October, whilst the US has added 900,000 bbls/day.
And as Bloomberg again writes, what is even worse for Saudi Arabia is that Russia has gained market share at its expense:
“[Russia] ratcheted up production to an unsustainably high level as the [November 2016] cuts were negotiated so it could just go back to normal output once the time came to cut. At the same time, Russia moved to take market share away from Saudi Arabia in one of its top export markets, China. This year, Russia is the top exporter to that country, displacing the Saudis.
What Happens Next
Oil prices actually fell last week after it was announced that OPEC and the Russians will very probably extend their production cutbacks until March 2018.
Crude is likely to come under a lot more downward pressure during the rest of 2017 and into early 2018 as US shale oil production continues to rise, and as innovation in the hydraulic fracturing process continues to accelerates.
The second chart below, from the US’s EIA, indicates the effect of existing innovation on output per well.
What will add to the momentum on innovation will of course be all the fresh capital that is pourig into the US oil patch. US breakeven production costs will thus continue to fall.
Here is another problem: US producers have also been able to take advantage of higher prices through an increase in hedging activity. As CNBC reports:
According to recent disclosures, producers have rushed to hedge, or lock in, oil prices above $50 a barrel after OPEC’s November announcement to cut production.
In its analysis of 33 of largest upstream companies with hedging programmes, Wood Mackenzie found that the companies have added an annualised 648,000 barrels a day of new oil hedges since the fourth quarter of 2016, an increase of 33% from the third quarter of the year and more than in any of the previous four quarters.
This puts US producers in an even stronger position to withstand lower oil prices.
US shale oil and gas are also two of the few genuine bright spots for the US economy. Drilling regulations might thus be relaxed by the Trump White House along with improved tax breaks. This would make US production even more competitive.
The end-result of all the above factors could be much higher US exports of both oil products and oil itself, now that the ban on direct exports of oil has been lifted. US crude exports reached their highest level in April since the ban was lifted.
Then there is China. The Paris-based International Energy Agency expects Chinese oil demand to expand by 400,000 bbl/day to 12.3m bbl/day in 2017. China is expected to account for nearly one-third of this year’s global increase in demand.
But our ICIS China team expects Chinese oil-import growth to slow down to just 5% this year from 13.6% in 2016, partly on a deceleration in economic growth.
The key economic growth determinant will be China’s willingness to continue to tackle its debt crisis now rather than later.
A further clear sign that Beijing is, for the time being, pressing ahead with economic reforms was the 34% fall in total social financing (TSF) in April compared with March. TSF, which is a measure of total lending in the Chinese economy, fell on a crackdown in speculative financing via the shadow-banking system. Interest rates have also risen as financing has become harder to obtain.
The renewed crackdown on credit is also linked with the politically very popular efforts to clean-up air pollution.
Put these two factors together and it seems very likely that China’s GDP growth peaked in Q1 2017 at 6.9% and will fall over the next few quarters.
China might, of course, pull back from economic reforms if growth falls by too much over the rest of this year and until 2018.
But I see this as very unlikely because Beijing knows that the longer that it delays tackling the debt crisis, the worst the problems will become.
China’s difficulties were underlined by Moody’s decision to last week lower China’s long-term local currency and foreign currency issuer ratings to A1 from Aa3. This was the first downgrade of China’s debt rating by Moody’s in nearly three decades.
Plus, the 6.9% growth that China achieved in Q1 was above expectations. This gives Beijing considerable leeway to slow growth down over the next few quarters, whilst still hitting its overall target for 2017 of 6.5% GDP growth.
It is also important to understand the role that China has played in global reflation of oil and other commodity prices since the middle of last year.
The re-inflation of its credit bubble is behind stronger apparent demand, up and down many global manufacturing chains, which I believe is one of the reasons for recent very stronger purchasing manager’s indexes in Europe and the US.
Take this reflation away as credit availability further declines in China and global growth momentum will be lost. This could obviously be another negative for oil prices.
At some point, Saudi Arabia and the rest of OPEC may decide enough is enough and return to their former market-share strategy. Saudi Arabia still has the lowest production costs in the world, and so it is well-positioned to regain export volumes from the US.
Crude at $35/bbl or lower by Q4 of this year is thus a scenario that I think you need to consider.