Oil at 5-year low: Where prices go will depend on who blinks first, shale producers or OPEC
The West Texas Intermediate (WTI) crude oil price has touched a five year low of $65 per barrel. As I write this, the WTI price stands at $64.5 per barrel. WTI is one of the grades of crude oil and is used as a benchmark to set oil prices. This fall in oil prices has come about after the Organisation of the Petroleum Exporting Countries(OPEC) in a meeting on November 27, 2014, decided not to cut their production. In the past whenever oil prices fell, OPEC used to cut production in order to ensure that prices did not continue to fall. This has not happened this time around.
The primary reason for the same has been the rise of the shale oil producers in the United States. The United States was producing around 4 million barrels of oil per day in mid 2008. Since then the production has jumped to 8.97 million barrels per day (as of end of October 31, 2014). The entire incremental production has come from shale oil.
This has meant that the United States which is the biggest consumer of oil in the world is importing far lesser oil than it was in the past. Amrborse-Evans Pritchard writing in The Telegraph points out that "America has cut its net oil imports by 8.7m barrels per day since 2006, equal to the combined oil exports of Saudi Arabia and Nigeria." This is a reason to worry for OPEC and it has decided to not cut production significantly, and in the process it hopes to make shale oil producers unviable.
Prtichard also quotes Chris Skrebowski, former editor of Petroleum Review, as saying that Saudi Arabia wants to cut down the annual increase in the production of US shale oil from the current one million barrels per day to 500,000 barrels per day. Saudi Arabia is the leader of the OPEC cartel and OPEC largely does what Saudi Arabia wants it to.
Given this it is not surprising that OPEC has continued to maintain a production of over 30 million barrels per day, despite falling oil prices. As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: "It is not surprising to see OPEC production - relative to its 30 million barrels a day quota - rising from virtual compliance to one where the cartel is producing above its agreed production allocation. Output rose to 30.974 million barrels per day in October, a 14-month high led by gains in Iraq, Saudi Arabia and Libya."
The production of OPEC in the month of November 2014 stood at 30.56 million barrels per day. This was lower than the production in October, but still higher than the target of 30 million barrels per day.
OPEC is working with the assumption that shale oil is expensive to produce. Nevertheless as I pointed out in an earlier piece on shale oil there are as many estimates on the production cost of shale oil going around, as there are analysts.In a September 2014 report Bank of America-Merrill Lynch had put the production costs of shale oil from $50-75 per barrel. Mian whose newsletter I have quoted earlier put the break-even price at $57 per barrel. Analysts at Citibank recently said that the price of oil would have to fall below $50 a barrel for completely halting shale oil production in the United States.
Evans-Pritchard goes even lower. As he writes: "The International Energy Agency said most of North Dakota's vast Bakken field "remains profitable at or below $42 per barrel. The break-even price in McKenzie County, the most productive county in the state, is only $28 per barrel." He quotes Edward Morse, Citigroup's commodities chief as saying that the "full cycle" cost for shale production is $70 to $80, but this includes the original land grab and infrastructure. Nevertheless, the remaining capital expenditure "to bring on an additional well, could be as low as the high-$30s range."
A Bloomberg report points out "Only about 4% of US shale output needs $80 a barrel or more to be profitable, according to the International Energy Agency. Most production in the Bakken formation, one of the main drivers of shale oil output, remains commercially viable at or below $42, the Paris-based agency estimates."
What these data points tell us is that the Saudi led OPEC will have to drive down oil prices further, in order to ensure that production of shale oil becomes unviable. At least that is the observation one can make from all the data that is available.The question is till when OPEC keep driving down prices. Mian estimates that "the current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion". Further, "lower the price of oil falls, the greater the need to compensate for lower revenues with higher production, which paradoxically pushes oil prices even lower," Mian writes.
Most OPEC countries have built their budgets around high oil prices. "Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment," writes Mian.
Hence, the oil price at which the budgets of OPEC countries and other oil exporting countries breaks even, is very high. "The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup,"writes Evans-Pritchard.
Given this, while the OPEC is trying to make shale oil unviable it is bleeding as well.
Nevertheless, Saudi Arabia seems to have decided that it wants to drive down the price of oil and that is what is important. The Kingdom has the ability to withstand lower oil prices for a few years, feels Mian. As he writes "Saudi Arabia appears to be comfortable with much lower oil prices for an extended period of time. The House of Saud is equipped with sufficient government assets to easily withstand three years at the current oil price by dipping into their $750 billion of net foreign assets."
The question is who will blink first, the Saudi Arabia led OPEC or the shale oil companies. And that will decide how far the oil price will fall.
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)
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