(This article was originally published in the 2017 Sept/Oct edition)
In Greek mythology Sisyphus was the king of Ephyra – modern-day Corinth. He was a sly and deceitful ruler who murdered travelers that came to his realm while engaging in other nefarious acts that angered Zeus, the ruler of all the gods. As punishment for his ways, Zeus consigned Sisyphus to eternally pushing a boulder uphill. Upon reaching the summit, the rock would roll downhill again and the process repeated.
Though separated by centuries and 1,700 miles, events in the global oil market are forcing Saudi Arabia to behave like a modern-day Sisyphus. For Saudi Arabia, the boulder is global oil inventories, the difference between supply and consumption. Lowering inventories is the burden Saudi Arabia, as head of OPEC, bears in order to lift oil prices.
The latest rock is the negative impact on energy demand of Hurricane Irma’s slamming into Florida, the U.S.’s fourth largest state economy. If Florida were an independent nation, it would rank as the 16th largest economy in the world, according to the World Bank, and its energy use is significant.
To understand Saudi Arabia’s challenge, we must relive some history. In June 2014, global crude oil prices peaked at $115 a barrel as the oil market recognized that supply was growing faster than demand.
Two industry drivers were at work. On the positive side, high oil prices – which had prevailed for four years – provided both the cash flow and the incentive for producers to launch a massive drilling effort in hopes of capturing more income. On the negative side, those same high prices reduced demand as expensive fuel proved too costly for many consumers, especially those in the developing world. Another demand depressant at work in the background was renewable energy.
Five months after the oil price peak, Saudi Arabia told its fellow OPEC members that it would no longer play the role of market balancer but instead would seek to regain its lost market share and would boost, rather than cut, output. The decision was a flashback to 1985 when Saudi Arabia took a similar stance, causing global oil prices to fall below $9 a barrel from the $28 a barrel the Kingdom had been unsuccessfully attempting to defend.
In that earlier episode, OPEC was a victim of the collapse in oil consumption due to the price shocks of 1973 and 1978, which collectively lifted oil prices from $3 a barrel to $32. The price jump crushed global economies. The experience of rapidly rising oil prices encouraged (maybe forced) every country with even a hint of oil and gas resources on its land or in its waters to open its borders to producers in hopes of reducing their reliance on OPEC oil. Today appears to be mirroring that history.
In 2014, after nearly two years of falling global oil inventories, the market changed. The first half of 2014 saw global inventories growing by nearly a million barrels a month amid signs that the rate of increase was accelerating. The years of high oil prices drove American oil explorers to start drilling oil shale formations, applying the technology developed by natural gas producers tapping the Barnett Shale in Texas and other gas shale formations.
The explosion in oil shale drilling produced an environment reminiscent of the mid-1980s – higher American oil output. A famous 2014 Wall Street investment research report characterized the dramatic change underway as creating “Saudi America,” and the Energy Information Administration reckoned that U.S. oil production would return to its 1970 record output of just shy of 10 million barrels a day by 2019. Supporting that view was the International Energy Agency’s declaration that by 2020 America would displace Saudi Arabia as the world’s biggest oil producer, pumping 11.6 million barrels a day.
The Other Side of the Equation
The heady days of $100 a barrel oil were working their magic. The problem was few people were paying attention to the consumption side of the equation, something that was starting to haunt Saudi Arabia’s oil ministry. Their concern was driven by the country’s inability to sustain its market share.
Moreover, Saudi Arabia was seeing other forces at work that augured an even more challenging oil market ahead. By October and November 2014, global inventories were rising at nearly two million barrels a day. Recognizing that the momentum of the industry was gaining strength, the prospect of even more volumes flowing into the global oil market was raising the fear indicator in Riyadh.
A market development that received little attention then, and even less today, was the reversal of restrictions on the use of Canada’s oil sands output by the European Union. Saudi Arabia recognized that the E.U.’s shift from banning “dirty oil” from Canada’s oil sands to allowing its use meant a more competitive marketplace would soon emerge. The Kingdom had already yielded market share in the U.S. to growing domestic output. The prospect of cheaper Canadian oil sands being available signaled that high-priced Saudi oil could be squeezed out of the European market too.
This left Saudi Arabia to compete with aggressive Russia and Iran for a larger share of the Asian oil market if it was to sustain its output. Although the Asian market is the most robust of all global markets, competition from Russia – given its long-term energy deals with China – and from Iran – desperate to boost its income – signaled a more competitive landscape that would not be hospitable to the Kingdom.
That mindset framed Saudi Arabia’s reckoning as it stared at the dilemma of high oil prices, rising inventories, growing production, anemic demand growth and shrinking market share. The solution was lower oil prices to drive high-cost output from the market and stimulate demand, especially in those developing economies with robust demand and high sensitivity to price levels. Amazingly, it was Saudi Arabia’s fellow OPEC members who were most surprised by the 2014 Thanksgiving Day meeting outcome as they failed to remember the organization’s history.
Impact of Mother Nature
Fast forward nearly three years from that fateful meeting and what do we see? Crude oil prices languish at the $50 a barrel mark. Global oil inventories have stopped rising, and hopes for them falling is supporting oil prices. That is why hurricanes and their impact on oil consumption is the new rock Saudi Arabia must continue to push uphill.
Analysts have pointed out that Hurricanes Harvey and Irma will likely reduce energy consumption even more than Hurricane Katrina in 2005. That storm led to a two percent reduction in the three months after the storm hit New Orleans. An early assessment of the recent storms’ impact on the petroleum market by Goldman Sachs concluded that U.S. oil inventories would rise by 40 million barrels, wiping out the shrinkage that occurred in July and August.
That is not a scenario that lifts oil prices higher, something Saudi Arabia wants and needs if it is to successfully sell shares in its nation- al oil company, Saudi Aramco, in an IPO scheduled for some time next year. Saudi Arabia has stated that its oil company will be worth $2 billion, and the offering of five percent of its shares will raise $100 billion for the country’s coffers. Financial advisors have reportedly advised Saudi Arabia that oil prices need to be in the $50-$60 a barrel range for their expected valuation to be achieved. That is part of the reason why Saudi Arabia continues to push rocks up hills.
Hurricane Irma’s path through Florida was on the western side of the peninsula and more onshore than originally forecast. The result was less damage than predicted although the damage in certain areas was severe. The significance of Florida’s energy demand destruction cannot be overestimated and is reflected in the fact that the state consumed 4.5 percent and 4.9 percent, respectively, of all petroleum and natural gas used in the U.S. in 2015. With population growth, those percentages have likely increased.
We have no doubt that Florida and Texas will rebound from their hurricane losses. Energy demand will be restored, but the challenge is not knowing how much demand has been lost and how quickly it will return. The record of Katrina’s impact on total U.S. oil consumption provides a useful guide and signals another challenge for Saudi Arabia in its efforts to lower inventories and lift global oil prices. Just how long will Saudi Arabia have to imitate Sisyphus? MarEx