Oil producers would be better off if some of them produced less. But who’s going to blink first?
Yesterday Igor Sechin, chief executive of Russian oil giant Rosneft, damped speculation that Moscow and Saudi Arabia were working on an agreement to curb production of the black stuff. He went on to blame OPEC, the oil producers’ cartel, for causing the oil crash by oversupplying the market.
Sechin had a point. Oil prices, which peaked at $112 a barrel in June 2014, settled at about $49 today. Analysts agree that mostly this has been caused by a glut in supply; because it refused to cut production when signs of weakness first emerged last autumn, OPEC is accused by many of having engineered the oil price’s precipitous fall.
But it looks like everyone else is equally misbehaved. True, OPEC output increased to 31.5 million barrels in July. Production by Saudi Arabia, Iraq and Venezuela, all members of the organisation, is at its highest in a year. But Russia also saw its output grow 1.3 percent in first seven months of the year. And while the US did record a slight decline, it is still producing much more than a year ago – when prices were more than twice as high.
Given that for now it is mostly supply that dictates the price, a decrease in global output would make oil producers collectively better off. So why is no one taking the plunge?
The answer depends on where you look. Some countries just really need the cash. The lower the oil price, the more they need to sell to maintain their revenue. This argument works especially well for Russia: the country has seen its currency drop in lockstep with the oil benchmark since last year, meaning that every extra barrel it sells, priced in dollar, brings the government the same amount of rubles (the budget’s currency). Moscow has little interest in producing less.
That is not the case of Saudi Arabia, whose currency is still pegged to the dollar. The country, rather, is keeping output unchanged for strategic reasons: it is waging a price war against US shale oil producers. Its hope is that lower prices will force these to close wells, allowing it to gain market share.
This hasn't really happened so far. Shale producers have showed an impressive ability to cut costs and utilise new technologies to improve output per rig – something the Saudis have perhaps misjudged.
So nobody’s made a move yet. But the oil price shows no sign of perking up, and neither global trade nor the Chinese economy seem in a position to give it a jolt. At some point something’s gotta give. So who’s going to blink first?
One way this question has traditionally been answered is by looking at the fiscal breakeven price of oil-producing countries – the price at which oil must be sold for states to balance their books. The figure is a complicated blend of different variables, including a country’s oil production costs, population size, domestic demand for petroleum products, total production, export volumes, non-oil revenue and government expenses. As such absolute estimates vary between data providers.
But their relative levels are relatively consistent across the board, allowing for insightful comparisons: the lower the breakeven threshold, the stronger the fiscal position of a given country. In principle that should tell you who’s going to lose the price war first. While Saudi Arabia and Kuwait have lower breakevens, for instance, Iran and Venezuela have much higher ones. It is therefore reasonable to think their economies will be less resilient to price shocks.
But breakeven prices remain a poor tool to predict the future behaviour of oil-producing countries. While being among the first to complain that prices are too high, for instance, Iran and Iraq have no intention to cut output. Quite the reverse, actually: they claim that years of war and sanctions should exempt them from being restricted by quotas, and are looking to crank up production.
Neither does the concept of breakeven price work very well for countries like the US or Canada, where oil, especially of the tight kind, is being extracted by a fairly fragmented group of private companies. There is no all-powerful oil minister in America that other nations can call to co-ordinate production levels.
More informative, for the purpose of our crystal ball exercise, is a broader set of economic indicators, technical data and qualitative information. Let’s take a look at each major producer in turn.
Some are not worth spending much time on. The oil industries of countries like Algeria, Venezuela and Nigeria, for instance, are beset by such problems already that production cuts there are hardly relevant. Others, like Mexico or Brazil, have seen their output fall as a result of underinvestment and political troubles – but that started before the oil slump, so neither is this going to make a difference.
In Russia, Angola, Norway and the Artic, a lot of big projects have been postponed or cancelled. Capital expenditure there has been drastically cut, the result of decisions that are hard to quickly reverse. Production forecasts for the next decade are being revised down.
But in the short run Russia is not going to budge, for the reason mentioned above. Western sanctions continue to hurt its coffers, and significant (yet diminishing) foreign currency reserves can help it withstand oil prices below breakeven.
Foreign reserves is also something Saudi Arabia has a vast amount of: recent estimates placed them at $672 billion (though they’re diminishing too). The country could devalue its currency, as can some of its Gulf neighbours, to earn more from each barrel it sells. And there are many other levers it can pull, even if using some of them would be politically toxic. Riyad doesn’t collect income taxes, and could start doing so; it pays out massive energy subsidies, which could be cut. The government’s debt stands at only 1.6 percent of GDP, leaving lots of room to borrow.
At this stage another indicator should be introduced: the cash cost, or the basic amount of money needed for an operational project to produce a marginal barrel of oil. This figure can vary significantly depending on whether the field is onshore or offshore, shallow or deep, etc. In the case of most Middle Eastern countries it is generally quite low (below $5 a barrel for Saudi Arabia, by some estimates). Prices would have to fall much lower still before it becomes unprofitable for Riyad to pump its reserves.
By contrast, US shale, though cheaper to produce than the Saudis originally thought, still has a higher cash cost than Middle Eastern oil. The break-even point is only $28 a barrel in McKenzie County, for instance, but it stands at $40 in the Balken formation and $85 in the Divide County.
And although greater cost-efficiency and productivity gains partly explain shale producers’ resilience, other factors may have played a bigger role. Widespread hedging, whereby drillers used derivative contracts to lock in higher prices, has allowed them to insulate a proportion of their revenues from the market slump. They’ve also benefitted from favourable refinancing conditions, as bank and investors have continued to provide them with liquidity until now.
But next year shale producers will face headwinds on both fronts. Most hedges will run out at the end of this year. They’re unlikely to be renewed: in the current market, it’s simply too expensive to fix future prices at $90 a barrel. That will make it difficult for producers to repay their combined $235 billion of debt, even as persistently low crude prices are starting to make them look unattractive to investors and lenders.
In this context, it is easy to understand why Saudi Arabia – and OPEC at large, though some members are reluctant followers – is standing its ground. Neither will it be satisfied with a temporary increase in price. What it wants is to permanently hurt US producers while making it impossible for prospective investors in shale to count on any kind of predictable returns.
Saudi Arabia and US producers are playing a game of chicken. Given that what’s at stake is not short-term profit but eventual market share, it’s likely to be a rather long one. Other oil exporters, meanwhile, are watching on the sidelines – they shouldn’t bank on higher prices before the game has a definitive winner.