What is Saudi Arabia’s Game Plan for Oil?

The Saudis seem to have decided to maintain their output of oil, while allowing the price to fall, so as to maintain market share.

But why?

Why haven’t they cut production to maintain the price of oil?

The following ideas have been put forth by various pundits to establish why the Saudi’s have maintained output:

  • To curtail or shut down U.S. shale oil production
  • To harm the Russian economy, and deter Russia’s actions in the Mideast
  • To harm Iran’s economy
  • To limit ISIS’ ability to obtain funding from selling high priced oil
  • To force other OPEC members to agree to making cuts
A History of Saudi Arabia, The Kingdom, by Robert Lacey.
A History of Saudi Arabia, The Kingdom, by Robert Lacey.

The following analysis attempts to discern whether the Saudi’s have maintained output in an effort to force the U.S. to cut its shale oil production.

U.S. shale oil production reached around 5.2 million bbl per day (mb/d) in 2014.

The decline rate during the first year of a new shale oil well’s production varies from 40% to 60%, so that, if drilling were to stop today, oil output would gradually decline during 2015, until output was reduced by 40% or more, or by approximately 2.5 mb/d.

This cut in supply would likely result in a balance between supply and demand.

But drilling isn’t going to stop immediately, and may not decline enough to significantly cut U.S. output.

The average number of rigs in operation in the U.S. during 2014 were approximately 1,850, of which around 350 were drilling for natural gas.

By one calculation, the rig count would have to drop to below 1,400 in 2015 to begin to cause a reduction in U.S. oil output, assuming the number of gas rigs remains unchanged.

Rig counts are readily available from Baker Hughes, and can be monitored during the year.

When breakevens for new wells are around $60 or $70, and the price of oil is around $40, new wells wouldn’t be drilled.

But many areas in the various shale plays have breakevens of $30 or $40 per bbl, which would work against drastically cutting the number of rigs.

If the U.S. rig count remains above 1,400, and if Saudi Arabia doesn’t cut output, and barring any unusual event, such as a war stopping production somewhere in the world, oil supply will remain unchanged, or possibly increase.

If oil supply remains unchanged, the price of oil will remain low until demand increases.

This implies low oil prices for an extended period, perhaps into 2017, depending on the growth in demand.

Another important factor is that it only takes a month, or so, to drill a new shale oil well. This means the U.S. could quickly ramp up supply, and take share away from the Saudi’s.

The factor that could work against drilling new shale oil wells during 2015 is the availability of bank loans to fund drilling, but there may be enough capex available to drill enough wells to keep output from declining significantly.

If this analysis is correct, it could mean the Saudi’s have made a miscalculation, or they have a different motive.

It should be noted that the lower oil price means the Saudis have less income, and must use their reserves to meet their other commitments, not the least of which is keeping their population satisfied. It’s estimated that the Saudis have enough financial reserves to last for a few years, so there is no immediate urgency for them to change course.

They also have spare capacity that could allow them to increase production by 1 to 2.5 mb/d.

If the Saudis have targeted U.S. shale oil production, they can confirm this by increasing output themselves, which would drive the price even lower, perhaps to around $20 per bbl. This would definitely curtail US production … at least for a while.

It may be six months before we have confirmation of whether U.S. production has decreased. It may take even longer before we can determine whether worldwide demand for oil is increasing.

It may well be the Saudis are attempting to curtail U.S. production, but it will be awhile before we can begin to reach any conclusions.

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