Many observers have been surprised by the willingness of Saudi Arabia to let the oil price collapse. But according to geophysicist and former geoscientist at Shell, Jilles van den Beukel the policy of the Saudis makes perfect sense. What is more, it is likely to succeed.



In 2014 Saudi Arabia decided not to limit production and to end their role as swing producer despite declining prices in the face of oversupply. This led to a precipitous drop in the oil price that is hurting OPEC and non-OPEC suppliers alike.

Why did the Saudis change their policy? Being swing producer is not a goal in itself. It is a way of limiting volatility (contributing to oil being seen as a reliable source of energy) and avoiding prices that are either very low (overly hurting revenue) or very high (hurting global oil demand and Saudi market share, and in the long term likely to result in lower prices). The overriding goal is to maximise oil revenue in the long term (although geopolitical considerations and internal stability provide boundary conditions).

It is becoming increasingly clear that climate concerns (and the resulting advance of renewable sources for power generation, electric vehicles) will affect demand

For short-term supply/demand fluctuations (e.g., a temporary drop in demand related to a financial crisis or temporary drops in supply arising from political crises) the Saudis are willing to defend price and continue in their role as swing producer. But for long-term, structural supply/demand issues, the Saudis feel they have no choice but to defend market share. The one time they did not do so was in the early 1980’s when for years they reduced production in order to support prices. After 5 years they found that keeping oil prices at a level way beyond the cost of incremental non-OPEC oil was simply not sustainable. By 1986, Saudi production had decreased to about 3.5 million barrels per day (against a total capacity of about 10 million barrels per day) and they opened up the taps.

Subsequently oil prices took about 15 years to recover. For the Saudis this was a defining moment that they are keen not to repeat. By being much more proactive this time they hope to limit the period of low oil prices (needed to bring supply and demand in balance, at an acceptable OPEC and Saudi market share) to a few years only.

Oil glut

I see a number of reasons why the Saudis concluded in 2014 that the oil supply/demand issues they were facing were structural, in line with advice from their consultants, who include both well-known western consultancy firms such as McKinsey and individuals such as Leonardo Maugeri, a former Eni vice president and one of the firsts to warn of a coming oil glut in a seminal 2012 paper.

Slowdown in oil demand growth. By mid 2014 the slowing down of oil demand growth, related to weak economic growth in Europe and China, became more pronounced. Oil demand in the OECD has been near constant for a long time due to increasing efficiency combined with limited economic growth. The slowdown in China is more significant, pointing at a gradual but important and long-term change from a more rapidly growing energy-intensive economy to a more slowly growing less energy-intensive economy. This has far reaching implications for long-term oil demand. At some time other Asian countries, in particular India, may experience a similar period of large energy demand growth as experienced by China over the last 15 years. This has not yet materialised and it may well turn out that a less well managed Indian economy may not be able to replicate what happened in China. In addition, for the long-term future, it is becoming increasingly clear that climate concerns (and the resulting advance of renewable sources for power generation, electric vehicles) will affect demand.

Oil supply expected to increase significantly in 2015-2020. Global upstream oil and gas investment increased from about 250 billion dollars in 2000 to close to 700 billion dollars in 2013. This investment cycle started in the early 2000s and boomed from 2010 onwards. In spite of all the problems oil and gas companies have been facing regarding reserves replacement these efforts did eventually bear fruit, partly in the form of reduced decline rates for existing fields and partly in the form of new developments (deepwater, oils sands). Whereas the first component tends to have a shorter lead time between FID and production, the second component tends to have a much longer lead time (of the order of magnitude of 10 years).

This is not just a Saudi war on US shale oil production. It is high cost production in general that the Saudis want to rein in

A 2012 bottom-up analysis of worldwide upstream projects (Maugeri, 2012) showed that, assuming a 2020 Brent Oil price higher than $70 per barrel, 2020 liquids production capacity was expected to increase to over 110 mb/day (from about 93 mb/day in 2010). The largest increase in production was expected in the US, Canada, Brazil and Iraq. This estimate took into account technical and political risk factors (the unrisked estimate being over 130 mb/day) and should be seen as a best estimate at the time, with a large uncertainty band around it (depending on the oil price, cost levels of the oil service industry, political stability in various countries, etc).

Nevertheless it started to become increasingly clear that a severe oversupply could exist by 2020 (the average yearly growth in oil demand needed to keep up with the base case oil supply was 1.6%; in excess of the average observed growth over the last 20 years).

A similar analysis by Rystad Energy (2014), based on their proprietary UCUBE database (of existing and future oil producing assets), also pointed to higher growth of supply, compared to demand, in the 2015 – 2020 period. Other consultancy firms have produced similar analyses.

US shale oil production. The most remarkable component of recent oil supply growth has been the unprecedented growth of US oil production – solely due to shale oil production.

The success of the US shale industry will be difficult to replicate but it cannot be ruled out that a similar development will take place in other parts of the world, at some stage (e.g. Argentina, China). Once a critical level of production, experience and service industry activity has been established it will be virtually impossible to stop.

A recent Rystad Energy analysis (based on a global database of fields and potential future assets) as shown in the figure below confirms that a continuation of current low oil prices in the long term is unlikely

The rapid increase of shale oil production (in combination with more general supply and demand issues) has been a very worrying development for Saudi Arabia. It is important for them to stop this rapid increase. For that they are willing to accept low oil prices in the short term. In the longer term this may preclude a sustained period of prices in excess of $80 – 100 per barrel, as such high oil prices would result in a renewed explosion of US shale oil production and, even more worrying, would increase the scope of shale oil production in other parts of the world.

This is not just a Saudi war on US shale oil production. It is high cost production in general that the Saudis want to rein in. If anything it is now a battle between US shale production and other high cost production areas, be it Canadian oil sands, deepwater, the Arctic or conventional mature fields (e.g., North Sea).

Will they succeed?

Before (gradually) going back on their current policy it is expected that the Saudis would like to see:

the arrest of the rapid growth of US shale oil production

global supply to have fallen below demand and inventories to have reduced to – or at least starting to approach – average long-term levels

confidence that a sufficient number of projects have been cancelled so that future oil supply is unlikely to exceed demand in the longer (5 – 10 years) term

US shale oil. The figure below gives a forecast for shale oil production, as made in late 2014 by Rystad Energy. It illustrates the high sensitivity of shale oil production to the oil price (rapid decline rates of existing production, short lead times for new production). Although I feel that lead times tend to be underestimated by many analysts (significant time is needed to secure funding, to hire or lay off rigs and fracking crews) it is clear that shale oil is faster to respond to changes in oil price than the conventional oil industry. The actual 2015 U.S. shale oil production is quite close to this late 2014 forecast (for the oil price as it eventually materialised). Within a single year, the low oil price has indeed resulted in the arrest of shale oil production growth (reducing oil production by approx 2 million barrels/day compared to pre oil drop forecasts).

Nevertheless 2015 shale oil production has been quite resilient. No massive wave of company bankruptcies has taken place. A number of factors come into play:

Cheap funding continues, albeit to a lesser extent. Bankruptcies and fire sales of assets are in no one’s interest. Hence there has been a tendency to be rather lenient regarding rollover of loans and reserves re-determinations (Oil and Gas Journal, October 2015).

A significant part of 2015 shale oil production was hedged (for approximately 50% of production of smaller companies, for prices anywhere in between $60 and $100).

Reduced drilling and fracking costs, faster drilling (poor performing rigs being the first to be laid off).

More focus on the best plays and sweet spots.

Land lease cost being sunk cost, there is often still an incentive to drill in order to minimise losses.

A gradual reduction of the number of drilled but uncompleted wells.

It thus seems likely that the Saudi objectives will be reached sometime 2017 or 2018. Oil prices will recover but the exact timing and magnitude are uncertain

2016 will be a much more difficult year though. Continuation of funding will be more difficult and expensive. Hedging of 2016 production at attractive prices is much less prevalent. At some stage companies may run out of their inventory of drilled but uncompleted wells. Surviving without any drilling and fracking of any new wells (“zombie companies“), just waiting for the oil price to recover, may at some stage be no longer sustainable. The December 2015 oil price drop below $40 per barrel does not bode well for 2016 prices and oil shale production. And although strong productivity gains have materialized over the last few years in the US shale oil industry, fFor some plays (Eagle Ford and Bakken in particular) these gains may now finally have reached a plateau.

Other non-OPEC production. A recent Rystad Energy analysis (based on a global database of fields and potential future assets) as shown in the figure below confirms that a continuation of current low oil prices in the long term is unlikely – given the resulting drop in non-OPEC supply (and assuming no dramatic surprises on the demand side). It illustrates the significant time between investment cuts and the resulting lowering of oil production. It also illustrates how severe the eventual production drop will be. A revised supply forecast (late 2015) from McKinsey for 2025 production is in line with the Rystad work.

In these forecasts a smaller supply growth from new projects is apparent across the board. The biggest reduction seems to be in new production from oil sands. 2010 cost curves still saw similar break even costs for shale oil and oil sands. 2015 cost curves have significantly lower break even costs for shale oil. It is striking that Exxon Mobil, the major with probably the best track record for capital discipline and project execution, is hardly active in oil sands, cautious and reluctant to go ahead with large deep water projects, but is keeping up its investments in oil shale (in particular in the Permian Basin).

Monitoring of upstream industry investments confirms that the flow of FID’s for new projects has indeed been reduced dramatically. Throughout the world many projects that had not yet passed FID – and even some that had, such as Shell’s Carmon Creek oil sands project – have been put on hold. The amount of cancelled or deferred upstream capital spending was approx $220 billion in mid 2015, compared to pre-price-drop estimates (WoodMackenzie, September 2015). It had increased to approx $380 billion by the end of the year (Financial Times, January 2015, subscription needed).

This will have a significant impact on production in 2020 and beyond but has a much smaller immediate effect. The short-term impact has to come from a further reduction in US shale oil as well as a faster decline of the production of conventional assets (reduced infill drilling and workovers).

Road Ahead

Saudi Arabia’s strong financial position (net foreign assets of about $740bn – mid 2014 – and minimal debt) has given them a good starting position for a period of low oil prices. It will take approximately 4 years before they will start to take on a net debt (debt greater than foreign assets owned). They have the financial resources (and in all likelihood the determination) to see this through.

The resilience of US shale production so far and the significant time it takes for ongoing investment cuts to result in lower production imply that supply and demand are only expected to approach a balanced situation by late 2016 or early 2017. The main uncertainty for the exact timing is Iraq/Iran production. Unlike high cost oil, this production cannot be reined in by the current low oil prices.

The world will likely face a prolonged period of relatively low demand as a result of reduced economic growth, improved energy intensity, climate concerns leading to CO2 pricing and increased support for renewables

Throughout 2017 and 2018 non-OPEC supply will start to drop at increasing rates as the fallout of the current investment cuts becomes more material. It thus seems likely that the Saudi objectives will be reached sometime 2017 or 2018. Oil prices will recover but the exact timing and magnitude are uncertain. Saudi Arabia’s preference may be that oil goes to a $60 – 80 range: sufficiently high to keep up non-OPEC production (with field declines being compensated by the best of deepwater and US shale oil) and sufficiently low to keep a lid on shale oil production on a global basis. New oil sands projects and the highest cost mature provinces (North Sea) will continue to struggle.

Instead of staying within a more sustainable $60 – 80 USD range, oil prices may of course overshoot again prior to 2020. The small current spare capacity and the severity of the current investment cuts increase the probability of this scenario.

On the other hand, a system change after which oil prices converge to the price of incremental low cost OPEC oil instead of converging to the price of incremental non-OPEC oil seems very unlikely. It is not in the interest of OPEC for sure nor is it in the interest of the developed world as it is likely to lead to a dramatic drop of oil company stock prices and will severely hamper the transition to a lower carbon world.

Much improved starting point

The Saudi efforts have a good chance of succeeding. They have been much more pro-active than in the 1980 – not waiting for market share to collapse due to high prices. No excessive Saudi spare capacity exists at the moment (if anything it is lower than the long-term average following a moderate increase in production in early 2015). The price of non-OPEC incremental oil is significantly higher now. They seem determined (and have the financial resources) to see this through 2016.

By 2017/2018 they should have made sufficient progress to let prices rebound. Should this require a limited drop in oil production then they will probably try and share that with other OPEC producers and Russia (with better chances of success than in 2014). Until that time they should give no early signals of a change in course, in order to maximise the drop in current and future non-OPEC supply. This would leave Saudi Arabia with a much improved starting point for the challenging years ahead.

The current upstream investment cuts not only reflect lower oil prices but also pressure from shareholders to safeguard dividends. In a more uncertain world (geopolitical, climate concerns, Saudi policy changes) oil majors will be more reluctant to go ahead with expensive long-term projects (oils sands, deepwater). Shale oil has the advantage that is more nimble, easier stopped and started with individual projects of much lower costs. Maximising value (in what is increasingly seen as a sunset industry) will take over from replacing reserves as the key objective for oil majors.

Will Saudi Arabia itself remain stable, now that the long reign of King Abdullah has ended and caution and diplomacy seem to have been replaced by assertiveness (and perhaps paranoia)?

Nevertheless, uncertainties remain. The world will likely face a prolonged period of relatively low demand as a result of reduced economic growth, improved energy intensity, climate concerns leading to CO2 pricing and increased support for renewables, giving a long-term downward pressure on oil prices. To what extent will renewable power generation and electric vehicles take of? Reserve replacement outside of OPEC remains a challenge for oil companies, giving a long-term upward pressure on oil prices. To what extent will shale oil production take off outside the U.S.?

In the meantime instability in the Middle East remains a source of concern. More intense Sunni – Shia divisions, mass youth unemployment and the partial US withdrawal from the region (the US now being close to energy independence) all play a role here. Will Saudi Arabia itself remain stable, now that the long reign of King Abdullah has ended and caution and diplomacy seem to have been replaced by assertiveness (and perhaps paranoia)? Will the current crown prince and deputy crown prince fall out?

Severe supply disruptions and resulting price hikes are conceivable. On the other hand: what happens if Iraq and Iran low cost production really takes off in earnest? In the long term this could result in OPEC having three key members instead of one. Will these three countries be able to reach an agreement to limit their production? If not then we could see low oil prices for real.

Conclusion

In the light of limited future oil demand growth as well as the rapid recent increase of US shale oil production and the expected increase of conventional oil production (following years of high investment) the 2014 Saudi policy change seems perfectly sensible. It is consistent with their long-term strategy: to maximise oil revenues in the long term.

Defending oil price at a level much higher than the cost of incremental non-OPEC oil is simply not sustainable in the long run. As in the 1980’s, this would only have resulted in a reduction of market share followed by a more prolonged subsequent period of low oil prices.

Saudi Arabia has the financial resources to continue the current policy for several years. It seems likely that by 2017 or 2018 they will have achieved their short-term goals: supply to have fallen below demand, a start of inventory reduction and confidence that sufficient projects have been cancelled so that supply is unlikely to exceed demand in the longer term. By that time they may aim for a $60 – 80 per barrel bracket.

Editor’s Note

Jilles van den Beukel worked as geologist, geophysicist and project manager and lastly as a Principal Geoscientist for Shell in many parts of the world. In March 2015, he resigned to become a freelance traveller and author. This article is a shortened version of a paper published on his blog Jilles on Energy,https://jillesonenergy.wordpress.com/2016/01/05/the-2014-saudi-oil-policy-change-paper/