Round 2 in battle of OPEC versus U.S. shale
Round one of the competition for dominance in the crude oil market is over. Let the crux of the battle begin.
The Organization of the Petroleum Exporting Countries, which produces a third of the world’s oil, is out of easy tricks to sell as much oil as it wants at a price that meets its members’ revenue needs. OPEC’s nemesis? U.S. shale companies.
Enough shale companies have survived the crucible of low prices that they are coming back strong. The fact that OPEC is limiting production now to keep prices from going down is giving them hope, even if the promise is really quite tenuous.
The contest is for share of the crude oil market, which has not grown as quickly as most experts expected. Unable to cooperate, oil producers are facing a battle of attrition to see who can suffer the most and stay in business.
Can shale really make money at current prices? Will OPEC allow U.S. crude exports to erode its market share or let prices drop even lower?
This new round started two weeks ago, when oil prices declined 10 percent. The international benchmark dropped below OPEC’s desired range on news of increased U.S. production and stubbornly high inventories. The international benchmark settled at $51.78 on Friday afternoon, just barely above OPEC’s $50 goal.
That’s because U.S. oil companies have been bragging about how they’ve cut their production costs more than 30 percent since Saudi Arabia allowed the crude price to collapse on Thanksgiving Day 2014. That surprise move was intended to put shale drillers
“The excessive production that I saw coming out of shale three, four years ago cannot be absorbed by the global market.” Saudi Energ y Minister Khalid Al-Falih
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Saudi Arabia can produce crude cheaper than just about anyone else, but oil is also the country’s primary source of income. In order to allow crude prices to float freely, at one point down to $29 a barrel, the government burned through its foreign reserves and borrowed heavily.
Last December, OPEC decided that low prices were taking too high a toll on its member countries and negotiated a deal with national oil companies around the world to take 1.2 million barrels off the market. Prices jumped back above $50, and OPEC ministers had high hopes for $60.
While the OPEC strategy bankrupted more than 150 shale drillers, many survived. And bankruptcy is often just a purgatory for oil companies, one from which they can emerge after finding new financiers, as many have done.
Traders sent prices higher on news of the OPEC deal, at least for a while. The move was in anticipation of a drop in the record amount of crude in storage and the continued depression in America’s shale oil fields. Neither has come to pass.
“The crude inventory overhang relative to last year continues to be the most worrisome,” said Anthony Starkey, manager of energy analysis, Platts Analytics, the forecasting and analytics unit of S&P Global Platts. “More time is needed to see whether the OPEC supply cuts will be sufficient in rebalancing markets in the first half of this year.”
To get ahead of any rebalancing, shale drillers are hiring more rigs to begin drilling again, adding 21 on Friday alone. My colleague David Hunn reports that U.S. companies will boost spending by $25 billion in 2017.
Shale company executives have said they are confident they can make money within the OPEC range of $50-$60 and increase production. That has clearly frustrated the Saudi energy minister, who doesn’t want any new production coming online.
“Certainly, I have made clear that the excessive production that I saw coming out of shale three, four years ago cannot be absorbed by the global market,” Minister Khalid Al-Falih told Bloomberg News. “We will see what levels of production are. We hope they will be manageable.”
This is exactly the scenario the Saudis wanted to avoid. They worried that if they cut production to raise prices, others would simply produce more to fill the void. Those extra barrels wipe out OPEC’s ability to set prices and ultimately lower revenue because they’ve lost market share.
As long as inventories are high, and shale drillers keep adding wells, prices are unlikely to go much higher. The real risk is that they could go lower if OPEC doesn’t renew the current quotas when the members meet again on May 25.
Will OPEC ministers see shale production go up and decide that production cuts will only lead to lost market share? If OPEC lifts its quotas, we will almost certainly see $40 oil again.
That’s a real dilemma for Saudi Arabia, which hopes to sell stock in its national oil company next year. Since the value of an oil company is directly related to the price of oil, low prices mean a lower valuation. But if given a choice between losing market share and delaying the stock sale, a delay could make more sense.
Like any good competition, there is no way to predict how this game will play out. The oil sector is extraordinarily complex and subject to geopolitical risks, not just economic ones. But that’s why it’s such a fun business to analyze, and an extraordinary one to invest in.