Saudi Arabia Will Support Oil Price After US Fracking Suffers

The Brent crude oil price has fallen from $115 in June to under $58 per barrel as of December 30, 2014.1

A lower oil price is where production costs make all the difference. For a long time, analysts have suggested that US production is substantially more expensive and therefore sensitive to oil prices. This is where the rubber meets the road, as the coming months may reveal the extent of fragility, waste, or mismanagement within the oil industry — in the US and globally.

What is the reason for this prolonged and unforeseen event? Who wins and who loses as it shakes out?

Mishka vom Dorp joined our team in 2010. He is a broker at Sprott Global Resource Investments Ltd.

Mishka wrote the following note to his clients giving his take on the situation, and why he believes the Organization of Petroleum Exporting Countries (OPEC) is a major player in the oil take down:

I believe the oil price would bounce back if not for OPEC’s decision to keep up oil production at the same rate. Since I believe that Saudi Arabia will eventually consent to reducing its production, I believe now could be a good time to consider investing in specific oil companies — ones with low debt and the ability to continue producing over a 3-year timeframe at these prices.

The Organization of Petroleum Exporting Countries (OPEC)

Oil is plunging due to oversupply from the US and OPEC countries, a strong dollar, and weak demand.

So why did Saudi Arabia, the de facto leader of OPEC, ignore calls last month by poorer members — including Venezuela and Iran — to cut oil production to help stop sliding prices?

Wouldn’t it be in their interest to attempt to send the price of oil back to June’s levels?

After all, at a higher price, they could produce fewer barrels and extend the reserve life of their reservoirs but still make just as much money.

We can’t know what goes on behind closed doors, but one thing is for certain: the decisions made by OPEC have a real impact on the global economy.

The oil price affects everything from food prices, to electronics, to the dream vacation you're planning with the family.

So why isn’t OPEC cutting back on production?

Russia and Iran

Russia and Iran are both highly dependent on energy exports to fund their governments and stabilize their currencies. Both have also been a thorn in Saudi Arabia's side due to tensions between their geopolitical interests.

Saudi Arabia, backed by the United States, has butted heads with both countries on a number of issues — including Syria and the removal of Bashar al Assad.

Though the Saudis are feeling the pain in their wallets, they know that the Iranians and Russians have more at stake politically2, at home and abroad, from a falling oil price. My belief (which is also held by many others), therefore, is that they may be willing to let the oil price slide for a while.

United States Oil

This is where it gets interesting, because it looks like the Saudis are playing on two tables at once.

Though they are allied with the United States on regional politics, Saudi Arabia has been worried by the oil renaissance3 in the United States, which has led to the US surpassing Saudi Arabia in oil production. 

Unlike Saudi Arabia, the US mainly drills unconventional wells, which cost a great deal more than conventional production methods.

‘Netbacks’ on these wells, the returns after subtracting production and transportation expenses, vary. But overall, marginal producers in the United States will be hesitant to drill more wells at this oil price. The methods used to drill and maintain these wells (hydraulic fracturing, artificial flooding, etc.) also lead to higher decline rates than traditional wells.

The US has to continuously drill more wells to maintain current production levels and offset the high depletion rates of these wells.

The majority of reserves on an average well have been produced within a year and half. If US producers do not maintain the pace of drilling new wells, we will surely see US growth in energy production dwindle.

So far, with recent oil prices falling, we have seen a reduction in the rig count nationwide.4

Furthermore, US producers use a greater portion of debt to finance drilling costs5 when compared to their Canadian counterparts. When the oil price was above $100 per barrel, this easy credit came pouring into the US oil sector. Now that oil prices have dropped, banks may begin to tighten their credit facilities, forcing companies to pay down debt instead of re-deploying their cash into new wells.

Once lower oil prices have caused sufficient harm to bring down competing production in the US, I believe that OPEC, led by Saudi Arabia, will gradually tighten their own production, forcing the world to pay a higher price per barrel.

For investors who are bullish on energy in the long term, I believe this could be a major opportunity.

Natural Gas and LNG (Liquefied Natural Gas)

Natural gas production and consumption are heavily constrained by transportation problems.

Transportation issues have created some large disparities in pricing across national borders.6 For example, the US natural gas price at Henry Hub sits below $4.00 per mBtu (million British thermal units). Meanwhile, in most parts of Asia, natural gas sells for over $10.00 per mBtu.

Freezing natural gas into a liquid state (LNG) and transporting it from low-priced markets like the US to high-priced gas markets such as Japan is an attractive trade.

In recent years, we have seen Asian LNG demand grow substantially faster than oil demand. The top consumers of LNG are Japan, Korea, China and Taiwan, which account for three quarters7 of world demand. Qatar is currently the world's largest exporter with Australia closing in to take the lead.8

Saudi Arabia does not have any LNG export terminals. Its domestic market is a net consumer of natural gas. So it's not a stretch to see that the Saudis are worried about their market share being overrun by the traditionally cheaper LNG market. After all, Asian demand accounts for over 2/3 of Saudi Arabia's export market, and they will fight tooth and nail to keep it that way.

Liquefied natural gas projects cost billions of dollars and take years of planning and development before production starts. Australia has a pipeline of over $190 billion in LNG projects that are either planned, proposed, or under construction.

Since the LNG price is roughly tied to the oil price, a slump in prices will put these projects at risk9 worldwide and ensure Saudi Arabia's dominance in the Asian energy markets. In fact, as I write this, Petronas and its partners in the Pacific NorthWest LNG project in British Columbia just decided to defer building their $36 billion LNG project citing the "intense market environment".10

If I’m right about their intentions, then the Saudis’ plans are already coming to fruition.

Venezuela and Iran

Poorer countries like Venezuela and Iran have asked for the richer OPEC countries to produce less in order to help support the oil price. Saudi Arabia is trying to keep these countries in line by limiting their bargaining power. If they want to lower quotas at a future date, they’ll want the poorer countries to take part of the production cut. Letting oil prices slide for a while makes them more likely to comply when that day comes.

To sum it up, Saudi Arabia’s inaction on reducing supply is far from irrational. It is actually the most sensible thing to do in the near term.

How long will they be willing to keep production at current levels? That is anyone's guess, but they are unlikely to change anything until they feel that their interests are secure. Only then will they move to cut production in order to support the price of oil.

The Saudis have over $750 billion foreign exchange reserves, which, according to Barclays, is enough to cover 30 months of imports.11 That provides us with a good ‘worst-case scenario’ for how long Saudi Arabia might acquiesce to a tumbling oil price.

If Mishka is right, we should expect to see OPEC keep up production while US production drops off. In the worldview of the Saudis, the decline will hopefully be enough to get rid of their competition from US shale production, while at the same time lessening the influence of their rivals in Russia and Iran.

Today, Mishka is particularly interested in off-shore oil exploration, where he sees a chance for juniors to make big new discoveries with the backing — and funding — of much larger oil producers.

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P.S.: You can contact Mishka vom Dorp for a complimentary portfolio review atmvomdorp@sprottglobal.com or by phone at 800.477.7853.

P.P.S.: Get more insights like this one by subscribing to Sprott’s Thoughts, free, here.

Mishka vom Dorp joined Sprott Global Resource Investments Ltd. in 2010. He works closely with Rick Rule, to identify oil and gas investments, where he has sought opportunities when the sector was out of favor. He maintains a highly contrarian philosophy and investment approach. Mishka holds an MBA in finance and a BSB in International Business form the Umeå School of Business and Economics. He is currently an Investment Executive at Sprott Global. Contact Mishka atMVomdorp@sprottglobal.com or call 800.477.7853.