April 4, 2017    9 minute read

Saudi Arabia’s Oil War: The Battle for the $60 Barrel

OPEC's American Shale Problem    April 4, 2017    9 minute read

Saudi Arabia’s Oil War: The Battle for the $60 Barrel

A short while ago, Saudi Arabia announced that its budget deficit had shrunk to $79bn in 2016, well below a record $98bn in 2015. This announcement is in line with the government’s intention to reduce Saudi Arabia’s oil dependency and invest more in infrastructure and other areas in order to stimulate its flagging economic growth.

For a country that used to be almost totally oil-dependent, this is a bold move. It shows that the new leadership under King Salman is doing everything necessary to make Saudi Arabia a better place to live for its ordinary citizens as well as more welcoming for foreign nationals to the Kingdom.

Vision 2030

“My first objective is for our country to be a pioneering and successful global model of excellence, on all fronts, and I will work with you to achieve that…..” King Salman Bin Abdulazziz Al-Saud

Vision 2030 is the long-term plan to rebalance the Saudi economy. Also known as the “National Transformation Plan”, this massive project calls for the sale of Saudi Arabia’s national oil and gas assets, including the huge state-owned Aramco oil company.

The government envisions a new approach to economic growth by reducing oil dependency and aiming for Saudi Arabia to become a global investment powerhouse as hub linking Asia, Europe and Africa.

In order to achieve its objectives and ensure it has the necessary investment capital required, the Saudi government will take several steps centred around two key goals:

  • Sovereign wealth fund: Saudi Arabia will work to transform the Saudi Public Investment Fund into a sovereign wealth fund (SWF), with assets valued at $2.5trn, making it the largest SWF in the world.
  • Aramco: the giant national oil company will be partially floated – a 5% stake, to be exact – on the local exchange, and the proceeds will be allocated to the new sovereign wealth fund.

Aramco’s valuation estimates range from $400bn to an astronomical $1trn, and it’s therefore expected that the flotation will come as a significant cash boost to the SWF.

Pumping Through the Pain

The financial challenges for Saudi Arabia stem largely from the fall in the global price of oil over the past two-and-a-half years. According to Bloomberg, 62% of government revenues came from oil last year, and in 2017 this is expected to rise to 69%.

At around $50 per barrel, Saudi Arabia’s oil industry still makes the country fortunes. Its daily crude oil production is currently at 10.64 million barrels per day, a slight increase over 2016.

However, its military involvement in two ‘proxy wars’ in Yemen and Syria as well a two-year price war with US shale-oil producers has resulted in lower oil revenues and lost market share. To this end, Saudi Arabia has reversed its export stance with the United States and is now focusing on China as its second biggest export market – in direct competition with Russia, which also exports to China. Both countries each share 14% of the Chinese crude oil market.

Meanwhile, Russian output exceeded that of Saudi Arabia in January 2017 at 11 million barrels per day, reaching its highest level in 30 years. As it stands now, Saudi Arabia has to contend on various oil fronts with the Americans in the West, the Russians in the East and Iran right across the Persian Gulf. And the Saudis are losing their patience.

Iran: l’Enfant Terrible

Iran, which is 90% Shia (Shi’ite) is the mortal enemy of Saudi Arabia, which is 95% Sunni and considers itself the centre of the Arab and Islamic world. Last year’s public execution of the prominent Shia cleric Sheikh Nimr al-Nimr further inflamed the hostility between the two countries.

Under the leadership of King Salman bin Abdulaziz al-Saud, who ascended to the throne last year, the Saudis are challenging Iran on multiple fronts. Saudi Arabia is determined to deprive Iran (and also Russia) of much-needed oil revenues in order to deter Iran from building up its oil industry.

Iran has retaliated with output increases, and at one point even threatened to sell crude oil at $1 per barrel on international markets now that international sanctions on its economy have been lifted. In addition, Iran it recently discovered an additional 15 billion barrels’ worth of crude oil and natural gas deposits, which if sold would only add to the global oil glut and depress crude oil prices even further.

On 18th February, the National Iranian Oil Company reported that Iran targets production of 4 million barrels per day by April 2017 and estimates it will reach 4.7 million barrels per day of crude oil by 2022. To achieve this, it plans to drill 500 new wells over the next five years.

However, even though Iran could significantly increase oil production in the coming years, it’s not making the necessary investments to achieve its objectives.

Frack Gold

Shale oil extraction, which involves hydraulic fracturing (or ‘fracking’, as it’s commonly known) has given oil producers the opportunity to extract ‘recoverable oil’ which is trapped underneath the surface in oil wells. Drilling for oil started in the Bakken Formation – a large subsurface rock formation spanning across North Dakota, Montana, Saskatchewan and Manitoba – in 1953, but only through recent technological advances has the North Dakota oil boom taken off.

Starting in 2006, shale oil production started at 200,000 barrels per day and increased steadily until a peak in 2015 when the Bakken Formation is estimated to have produced over 1.2 million barrels per day on average. Since 2014, though, when the global oil price slumped from over $100 to below $30 per barrel, shale oil extraction has been reduced significantly, with many distressed oil producers going into insolvency or bankruptcy.

Depending on the drilling area, the technology used and oil extraction efficiencies, the cost of shale production ranges anywhere from $40 to $60 per barrel, with the key range being around $40-$50 per barrel.

At the average break-even level of $50, it’s not economically viable for many US oil producers to start drilling anew and re-enter the global oil markets. However, easy access to capital and the lure that the oil price soon might recover – and potentially go even higher than $60 – has kept many oil producers going, notably ‘Marathon Oil’. This is despite the fact that Bakken oil production dropped a whopping 9% in December 2016.

One Eye on the Rival

It is for this reason that Saudi Arabia’s oil industry does not want the price to go any higher than $60 per barrel. At that level, the resurgent US fracking industry would start to make profits again, which could spur more production and flood the global oil markets with crude oil – the global surplus is currently estimated to stands at 1-2 million barrels per day. US shale-oil producers could easily add 1 million barrels per day should it become economically viable, and that is something OPEC has to contend with.

The comparative advantage to other oil producers such as offshore and deepwater oil drilling companies is that fracking wells can be shut down and restarted very quickly, so any upswing in the oil price can immediately be addressed. This makes the imminent surplus oil potential from the US fracking industry something that  OPEC must absolutely take into consideration.

OPEC agreed to cut production late last year, and the agreement has been holding – to the surprise of many, especially Saudi Arabia which has on many occasions experienced other member countries not sticking to their quotas.

Oil prices have strengthened now for several months, but in recent weeks, United States oil stockpiles have built up to a staggering 533.1 million barrels. This means the prospects of stronger oil prices have faded, especially since US output is expected to reach 9 million barrels per day by the end of 2017.

The New Oil Order

The days that Saudi Arabia, Russia and OPEC controlled the global oil markets on their own is now history. Goldman Sachs recently coined the term New Oil Order, which simply means that whatever happens in the global oil industry, it is no longer just OPEC and a handful of non-OPEC countries like Mexico, Norway, Russia, Oman that decide the price of oil.

In the New Oil Order, the US plays a key role due to its shale oil revolution which has made it a formidable oil exporter, as opposed to a net importer of foreign crude oil.

The decision process no longer rests with governments only: many independent producers can up-end the market to some extent by increasing production at will. Since they are no quotas to adhere to, US oil producers are free to take not their own production and viability decisions.

A Web of Forces

As with any commodity, many market forces come into play in determining the oil price. Wars around the globe have added another dimension and now technology is having a significant impact too.

Efficiencies in technologies will continue to buttress supply levels as oil producers develop their extraction techniques, though another major technological impact will come from electrically-powered vehicles (EV) and battery storage improvements, which will curb the demand for oil significantly.

At the other end, experts argue that EV will not have a major impact on global oil demand as other sources of demand – including industry, military requirements, and planes, ships and trains – are expected to grow significantly, potentially offsetting any increase in the supply of oil.

The current oil supply and demand equilibrium is beneficial to the global economy because large variations in the oil price negatively affect world trade and often cause conflict. Only time will tell what will happen in the years to come, but for the time being, the price level of crude oil at around $50 is ideal, striking a good balance between current supply and demand.

Saudi Arabia, however, wants a $60 per barrel level so that it can keep the shale-oil industry at bay. But it finds itself in a dilemma: when the oil price is too high – above $60 per barrel – US shale oil producers can restart almost at the flick of a switch, yet when the oil price is too low, much-needed oil revenues and market share will be lost. Finding the right balance will be of crucial importance so that Saudi Arabia can reach its objective of becoming a non-oil-dependent country by 2030.


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