OPEC'S Recurring Nightmare

AMERICAN SHALE HAS BECOME THE FREDDIE KRUEGER OF OPEC.

On May 25 oil ministers from the Organization of Petroleum Exporting Countries (OPEC) will assemble in Vienna for the 172nd Ordinary Meeting of the 57-year-old organization. At every meeting over the past three years, they have been haunted by the organization’s version of Freddie Krueger, the horror film character from A Nightmare on Elm Street who used a glove fitted with razors to kill his victims in their dreams, causing their deaths in real life.

Today, the ministers’ Freddie Krueger comes in the form of the relentless success of U.S. oil producers’ coaxing output from here- to fore unproductive shale formations. OPEC’s crashing of oil prices briefly paused the American shale revolution, but producers have adjusted and are once again ramping up output.

For OPEC, Freddie Krueger is more than American shale. His appearance in the 1984 movie coincided with OPEC’s first battle against rapidly growing global oil supplies caused by its pricing actions. Back then, OPEC was suffering from the unintended con- sequences of the oil price explosion of the 1970s, which commenced when a handful of Arab oil exporters used their supply clout to punish the U.S. and its allies who had supported Israel during the Yom Kippur war of October 1973. By the time the boycott ended in March 1974, world oil prices had quadrupled from $3 to $12 a barrel, and a full-scale global recession was underway.

In 1980, when the Iranian government was overthrown by religious theorists and its oil exports representing four percent of world supply – ceased, oil prices doubled to $40 a barrel. These geo- political events stimulated global exploration efforts that produced meaningful new oil supplies, a development that still haunts OPEC oil exporters. The jump in oil prices during the 1970s led to nearly 20 years of depressed prices, a period of pain for producers but a windfall for consumers.

DÉJÀ VU ALL OVER AGAIN

Today’s OPEC horror movie is a rerun triggered by the mid-2010s’ explosion in global oil prices to over $100 a barrel in response to the commodities’ supercycle powered by China’s economic growth. The prospect of continuing Chinese growth prompted exploration investment to mushroom. Between 2003 and 2014, capital spending increased fourfold, reaching over $700 billion. Supply growth was further stimulated by the technical success of shale gas exploration and its application to tight oil resources throughout the U.S.

As a result, U.S. oil production nearly doubled between 2007 and 2015, rising from 4.9 to 9.6 million barrels a day. The increase came as oil output from other countries like Canada and Brazil also grew. Adding fuel to the fire were higher Iranian oil output, following the lifting of U.S. and European economic sanctions as a condition of the U.S.-Iranian nuclear deal, and the resumption of exports from Libya as its political turmoil abated.

By June 2014, as crude prices peaked, U.S. oil output reached 8.7 million barrels a day on its way to 9.6 million the following April. Growing U.S. tight oil supplies, combined with other global supply in- creases, boosted world oil inventories and depressed prices. In response, in the fall of 2014 Saudi Arabia abandoned its production discipline whereby the kingdom adjusted its output to support oil prices. Its new goal became recapturing the lost market share resulting from that discipline.

While many analysts saw Saudi Arabia as targeting U.S. shale producers, it actually knew very little about the economics of shale. It was, however, well aware of the high breakeven costs of large, long-lived production from oil sands and deepwater offshore fields, which it regarded as a greater long-term danger to the country’s market share than shale oil.

What it learned over the following two years, to its dismay, was that advances in drilling and completion technology, augmented by the ingenuity of American shale oil producers, could sharply reduce shale breakeven costs, enabling companies to generate sufficient cash flows to remain in business despite low oil prices.

The pace of the American shale revolution accelerated when the deep-pocketed international oil majors and large, healthy American independent oil companies embraced it. The embrace was driven by two considerations: First, if global oil prices were to remain low for the foreseeable future, then all high- cost development such as oil sands and deepwater projects not already underway needed to be postponed. Second, investors were rewarding companies active in shale oil developments because those projects provided rapid investment paybacks and increased company operating flexibility since the activity could be ramped up or down in line with shifting prices.

BALANCING ACT

At the May OPEC meeting, oil ministers are likely to extend the production cut agreement reached last November to remove 1.2 million barrels a day of supply from the market. With the support of Russia and several other non-OPEC exporters, the combined group agreed to remove 1.8 million barrels a day of supply in an effort to rebalance the market even faster.

Now, however, the resilience of American shale oil producers is leading to rising supply forecasts despite high compliance by the export group with its production cut target. The April Monthly Oil Report of the International Energy Agency projects that global oil production will increase by 485,000 barrels a day on average in 2017 versus a 790,000 b/d decline in 2016. Importantly, the IEA expects U.S. oil production to increase by 680,000 b/d by the end of 2017, an increase from its March forecast. We will not be surprised if the IEA’s May report predicts a further supply increase.

That would be consistent with the U.S. Energy Information Administration’s latest forecast that calls for U.S. oil production to rise by 440,000 b/d in 2017 and a further 650,000 b/d next year, reflecting the industry’s current momentum. These projections are substantially higher than forecasts the agency made as recently as this February. Overall, the EIA is now estimating non-OPEC oil supply to grow by 870,000 b/d this year and 1.14 million barrels a day in 2018, wiping out a substantial amount of the current output cut engineered by OPEC.

While non-OPEC production is growing, global oil demand is slowing, further frustrating OPEC’s efforts to rebalance the market. After rising by two million barrels a day in 2015 due to the sharp drop in prices, demand grew by only 1.6 mmb/d last year and is forecast to increase this year by only 1.3 mmb/d, down 100,000 b/d from the March projection.

The reduced demand for 2017 comes in response to oil prices being forecast in the $50s to $60s a barrel range, up from the mid-$40s last year, and the even lower prices the prior year. This pattern of demand growth suggests oil markets and economies are struggling to grow in the face of higher prices.

VISION 2030

As reluctantly acknowledged by its leadership, the easiest way for Saudi Arabia to deal with OPEC’s recurring nightmare is to diversify its economy and reduce its dependence on oil. This is at the heart of the Vision 2030 plan unveiled last year by Deputy Crown Prince Mohammed bin Salman.

Getting Saudi Arabia off its reliance on crude oil exports has been called an impossible task. One analyst has calculated, based on applying the latest data on the reserve decline rates of large global oil fields, that Saudi Arabia may run out of oil by 2030, which coincidently is the first year of bin Salman’s plan for the new Saudi economy.

At the beginning of May, Saudi Arabia’s King Salman made a significant change in economic policy by restoring earlier salary and benefits cuts for ministers. He gave salary increases to the military and air force pilots fighting in the Yemeni conflict and made some oil, economic and military leadership changes. The timing of these moves was explained by the country’s deficit being reduced more than expected and the economy’s earning more from non-oil sources than anticipated.

The ability of Saudi Arabia to tap global debt markets twice in the past year further demonstrated that the kingdom’s financial health is stronger than many critics have contended.

Additionally, bin Salman told reporters in a television interview that the country’s debt-to-gross domestic product ratio, currently at 13 percent, would not go above 30 percent – in contrast to certain western economies where the debt-to-GDP ratio is 100 percent or greater.

Skeptics claim that Saudi Arabia is incapable of diversifying its economy sufficiently to escape dependence on oil for a substantial portion of its income. The Vision 2030 plan, and its rapid development, suggest Saudi Arabia is determined to end the horror movie reruns and begin a new era not tied to the highly politicized oil market.

-MarEx