Investors in energy have watched the United States go from the 3rd largest producer of oil in 2013, to the largest in the world this year. American production has overtaken both Russia the former largest producer, and Saudi Arabia. The United States had already become the largest natural gas producer in 2010, thanks to hydraulic fracturing also known as fracking and the shale boom.
Production of oil is surging in North Dakota and Texas, as any visitor there can see. Daily output now exceeds 11 million barrels of oil. The United States is still importing over 7 million barrels of oil a day and remains the world’s largest oil consumer. American production is due to increase on a yearly basis peaking at around 13.1 million barrels daily in 2019. It will remain the global leader in production until the end of the 2020s. Annual investment in the industry has reached $200 billion USD (United States Dollar) in the country.
Despite the increase in American production, it is Saudi Arabia that will determine oil prices on a global scale, because they are the largest exporters of oil in the world. The country has 16% of the proven worldwide reserves. Only Canada exports more oil to the United States than Saudi Arabia.
Saudi production is less than American production, but most of it is exported. Their only real competition in the export market is Russia, which in the long run will be facing declining production. This will be due to a lack of investment and expertise in developing new resources in Siberia. However, for now Russia is likely to expand production.
Saudi Arabia is now open to lower prices for an extended period, possibly as much as two years. One advantage of this new policy is that it undercuts potential rivals, who need higher prices to expand production. The Saudis can produce oil for half the cost, if one is using the United States as a comparison. So the Saudis can much easier afford lower prices for oil when it suits their strategic needs.
The question for investors is how low? The kingdom is comfortable with prices dropping as low as $80.00 USD a barrel, for an extended length of time. This will allow Saudi Arabia to hold world market share for years to come. Lower prices slows down exploration for new oil sources and increased production elsewhere in the world.
Saudi Arabia which produces roughly one third of OPEC (Organization of the Petroleum Exporting Countries) oil, is unwilling to cut any of the present 9.7 million barrels that are produced in the kingdom on a daily basis. Altogether, OPEC produced 400,000 more barrels of oil in September than in August.
Saudi Arabia along with its ally Kuwait, have both stated that small production cuts will not lower prices very much with output in the United States and Russia still expanding.
Lower prices will begin to inhibit production when they hit $76 -$77 USD. Below that some energy resources are no longer profitable to develop, especially offshore drilling.
Since economic growth is slowing in many areas of the world demand will fall regardless, thus ensuring lower prices unless there are major cuts in oil production.
Saudi Arabia has already cut its regular price to customers in the all important Asian market this month. Brent oil is the global benchmark for oil. The price of Brent oil which sells for a higher price than WTI (West Texas Intermediate) in the American market, has averaged in price of around $103 USD since 2010. Without cuts in production, the present price structure will be impossible to maintain in the present world economic situation. Recently prices are now lower than they have been since 2011, as a result of turmoil in the Middle East and North Africa. Brent sold yesterday for $88.89 USD a barrel, after another 1.5% percent decline from the previous week. The November contract is now selling for $88.19 USD. WTI is already at $85.06 USD for next month. Overall,prices have slid by more than 20% since the summer.
The world consumes about 90 million barrels of oil a day and there is about 1 million barrels surplus that is growing, as demand continues to slacken. Oil consumption has declined in the industrialized world by 200,000 barrels from last year. Consumption in the United States which moved up almost 500,000 barrels a day in 2013, is projected to decline by 40,000 barrels daily this year. If oil drops below $80.00 USD indefinitely for WTI, the further expansion of shale oil becomes nonsensical. This would be most acute for smaller firms. Larger companies might be able to absorb costs as low as $70 USD, maybe even $60 USD. Larger firms are more likely to employ new technology that makes drilling increasingly efficient.
Lower energy prices will be a welcome relief to the struggling countries of the industrialized world and those of emerging markets as well. The only countries that will be hurt economically, are those that depend on major sales of oil to balance their books. So even a nation like Norway who is a fossil fuel exporter, can afford lower prices because of wise past investments and savings in the energy sector.
This state of affairs could rapidly reverse itself, if world events threaten production. The Islamic State could move against the Iraqis oilfields in the south for example. The situation in Libya could deteriorate further as well, which would reduce the flow of oil from that country. Libya has been able to resume more regular production, expanding output by more than 500,000 barrels a day.
The assumption was until this month that with demand slackening, Saudi Arabia would cut production. They have not done so. In fact, the kingdom increased production last month by 100,000 barrels a day. In addition to maintaining market share, what else could be happening behind the scenes? Some other member nations of OPEC are not content to what is now occurring in the oil market. Iran is already demanding production cuts and Venezuela is nearly in a panic with the price drop. Venezuela’s already fragile oil dependent economy, will collapse if oil prices keep falling.
The discontent is not limited to just those two nations. A large portion of the Russian national budget is dependent on oil sales. As a result of sanctions and war in the Ukraine, the Russian economy is already nearly in a recession. Lower energy prices will dip the country into negative growth and put the Russian ruble even in more dire straights.
This makes one believe that something unusual is now occurring. The domestic benefits to the United States are obvious concerning lower energy prices. More dubious is how it will effect nations that are in conflict with American and Western interests. Fracturing the cohesiveness of OPEC is just the most open result, of the surge in Saudi production. This has long been a foreign policy goal of the United States.
Something happened in September when Saudi Arabia decided not to cut production, in the face of too much global supply of oil. When they started to ramp up production instead, analysts knew something was afoot. It is now obvious, that a deal had been struck between the United States and Saudi Arabia.
What an investor must first consider is how Saudi Arabia intends to sell the oil. The game with them is they will make up in volume, what they lost in price. It started in the Asian market, and now they are employing the same tactics in the European market. Potential buyers must commit to large shipments in advance, to benefit from the lower prices. Once stockpiles are full, this will become a problem for energy providers in Europe and in Asia. By that will occur in 2015. In the meantime the benefits to the United States foreign policy are immense.
In Latin America, it makes further mischief from Venezuela impossible. Declining oil prices will disallow this country to use oil as a weapon against the United States and its allies. Selling discounted oil to Cuba and various nations in the region including the Caribbean, will need to be curtailed. In the present desperate economic situation the government of President Maduro, the successor to Hugo Chavez, is unlikely to survive in Venezuela.
In Europe, further Russian adventurism becomes more difficult. Lower energy prices will hurt Russia far more than if the United States had decided to arm the Ukrainians. President Putin will be far less likely to take action against the Baltic Republics and other former nations of the Soviet Union, when oil revenues are plummeting. He cannot ignore a declining economy forever. He will not give up Crimea, but might be more open to a compromise in eastern Ukraine. He has already announced a withdrawal of Russian troops near the border. Of course, this could once again be just a ruse for now. But as the sting of lower energy prices become more potent, it may become a necessity.
Russia will be unable to threaten the rest of Europe with promised energy deliveries as much in an era of declining prices. The oil and natural gas dependent countries of Europe can more readily find alternatives, at a time when there is abundant supplies.
The Russian government already has been forced to spend nearly $6 billion USD in just the past 10 days, to slow the descending ruble. Prices are now rising rapidly in Russia making the government goal of reducing inflation below 5% impossible. Imports will become much more expensive. The sanctions will continue to impact Russia and will hurt the Russian economy even further, as Putin has decided to ban imports of foodstuffs from nations that are imposing such tactics. The government has promised a price freeze on 40 vital goods if prices jump more than 30%. This only guarantees shortages of these items. In the end it will not work. Price controls never do in the long term. Putin’s popularity will begin to plummet under these conditions.
In the Middle East lower oil prices will definitely hit an already staggering Iranian economy. The hope in the West is that will make the government in Iran more amenable to a deal over the country’s nuclear program. Iran will not openly be forced into an agreement, but a bargain might be worked out in secret. It will be one way to stop a wider war in that part of the world. Israel has already let it be known, that they will not accept a nuclear armed Iran.
A global glut of oil also makes the Islamic State less threatening. Even as they take over more of the Iraqis energy production, a world that is awash in oil will notice far less. Besides they will intend to sell the oil themselves. It will be done illegally of course, putting an even stronger downward pressure on prices. Buyers will demand a big discount to this illicit oil production. These newly acquired oil fields are also likely to be bombed and therefore taken out of production in the near term at least.
Declining oil prices will also impact North Korea. Nations like Iran who support belligerent action on the part of the country, will be less able to assist them in this endeavor. Nuclear missile threats from the North Koreans have caused oil prices to climb in the past. In a world with abundant oil, the threat of disruption to energy deliveries will have far less bite to it. Falling oil prices will make the government of North Korea less likely to sell nuclear technology to rogue groups and nations, as the need for foreign currency diminishes.
Finally, the Saudis have a policy goal of removing President Assad from power in Syria. It is no mere coincidence, that the bombing of Syria by the United States and coalition partners occurred when it did. Along with the degrading of the forces of the Islamic State there is no higher priority to the Saudi government except perhaps, preventing Iran from acquiring nuclear weapons.
Lower oil prices are now a reality and will remain so for the near future. If production is impacted somewhere in the world ,Saudi Arabia can simply ramp up production further. This is up to a point, of course. This writer for one, does not believe that Saudi Arabia can increase output as much as their government claims. Rather than plan on higher prices, investors should now consider shorting oil and natural gas in the short term.