Streetwise Professor

March 10, 2017

US Shale Puts the Saudis and OPEC in Zugzwang

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 2:55 pm

This was CERA Week in Houston, and the Saudis and OPEC provided the comedic entertainment for the assembled oil industry luminaries.

It is quite evident that the speed and intensity of the U-turn in US oil production has unsettled the Saudis, and they don’t know quite what to do about it. So they were left with making empty threats.

My favorite was when Saudi Energy Minister Khalid al-Falih said there would be no “free rides” for US shale producers (and non-OPEC producers generally). Further, he said OPEC “will not bear the burden of free riders,” and “[w]e can’t do what we did in the ’80s and ’90s by swinging millions of barrels in response to market condition.”

Um, what is OPEC going to do about US free riders? Bomb the Permian? If it cuts output, and prices rise as a result, US E&P activity will pick up, and damn quick. The resulting replacement of a good deal of the OPEC output cut will limit the price impact thereof. The best place to be is outside a cartel that cuts output: you can get the benefit of the higher prices, and produce to the max. That’s what is happening in the US right now. OPEC has no credible way of showing off, or threatening to show off, free riders.

As for not doing what they did in the ’80s, well that’s exactly OPEC’s problem. It’s not the ’80s anymore. Now if it tries to “swing millions of barrels” to raise price, there is a fairly elastic and rapidly responding source of supply that can replace a large fraction of those barrels, thereby limiting the price impact of the OPEC swingers, baby.

Falih’s advisers were also trying to scare the US producers. Or something:

“One of the advisors said that OPEC would not take the hit for the rise in U.S. shale production,” a U.S. executive who was at the meeting told Reuters. “He said we and other shale producers should not automatically assume OPEC will extend the cuts.”

Presumably they are threatening a return to their predatory pricing strategy (euphemistically referred to as “defending market share”) that worked out so well for them the last time. Or perhaps it is just a concession that US supply is so elastic that it makes the demand for OPEC oil so elastic that output cuts are a losing proposition and will not endure. Either way, it means that OPEC is coming to the realization that continuing output cuts are unlikely to work. Meaning they won’t happen.

OPEC also floated cooperation with US producers on output. Mr. al-Falih, meet Senator Sherman! And if the antitrust laws didn’t make US participation in an agreement a non-starter, it would be almost impossible to cartelize the US industry given the largely free entry into E&P and the fungibility of technology, human capital, land, services, and labor. Maybe OPEC should hold talks with the Texas Railroad Commission instead.

Finally, in another laugh riot, OPEC canoodled with hedge funds. Apparently under the delusion that financial players play a material role in setting the price of physical barrels, rather than the price of risk. Disabling speculation could materially help OPEC only by raising the cost of hedging, which would tend to raise the costs of E&P firms, especially the more financially stretched ones. (Along these lines, I would argue that the big increase in net long speculative positions in recent months is not due to speculators pushing themselves into the market, but instead they have been pulled into the market by increased hedging activity that has occurred due to the increase in drilling activity in the US.)

Oil prices were down hard this week, from a $53 handle to a (at the time of this writing) $49.50 price. The first down-leg was due to the surprise spike in US inventories, but the continued weakness could well reflect the OPEC and Saudi messaging at CERA Week. The pathetic performance signaled deep strategic weakness, and suggests that the Saudis et al realize they are in zugzwang: regardless of what they do with regards to output, they are going to regret doing it.

My heart bleeds. Bleeds, I tells ya!


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  1. I’ve long wondered why the US doesn’t put pressure on Saudi and chums by the following simple technique. (i) Put a sizeable federal tax on hydrocarbon fuels. (ii) To avoid that being deflationary, and to avoid it bearing too hard on the working poor, cut taxes on employment in equal amount.

    Of course I can see why it’s not been done.

    Comment by dearieme — March 10, 2017 @ 7:15 pm

  2. I seriously can’t muster any empathy towards them.

    Comment by tegla — March 10, 2017 @ 11:43 pm

  3. I think the question is /was not if US shale oil production can or will recover with prices >40 $/ Bbl

    But 1. What is the overall shale capacity (actually it’s more about capacity of lower cost producers in general- elastic or inelastic)? 2. What happens to ‘conventional’ inelastic higher cost oil production at this price level?

    I’ve not seen these questions discussed prominently recently , the only thing I remember reading re 1. was a piece put out by a bank when oil was still trading >100$/ Bbl, they forecasted US shale production to rise to up to 12 mb/d a day and stabilize there , it’s around 9 mb/d ATM, I think hey also assumed prices would fall to around 80$/ Bbl in that scenario… I assumed it to be some kind of hypothetical production capacity limit. Not sure how this number evolved taking into account current price level and improved technology.

    re 2. I think OPEC’s eventual objective is not to “destroy” the shale producers but to achieve supply destruction in “conventional” production, I may be wrong, but taking into account investment cuts have been severe this objective may well be achievable at some point in time as global demand is forecast to rise at around 1.5 mb/d. The point when this is achievied depends on the capacity limit for lower cost producers.

    Before that objective is achieved OPEC tries to maximize the oil price as it’s more or less clear that even the wealthier OPEC countries will crack at prices around 30 $/ Bbl pretty quickly and that that price will not necessary quicken the roll off of “conventional” inelastiv higher cost production. Of course they can devalue their pegged currencies, but that would be a pretty risky move for them given effects on inflation.
    Before that objective is achieved OPEC tries to maximize the oil price as it’s more or less clear that even the wealthiest OPEC countries will crack at prices around 30$ pretty quickly and that price will not necessary quicken the roll off of conventional productione. Of course they can devalue their pegged currencies, but that would be a pretty risky move for them given effects on inflation.

    Comment by Refdry — March 11, 2017 @ 6:12 pm

  4. Saudis in invidious position. Hence the histrionics.
    It’s not so much the current price of a barrel of oil that vexes them as the prospective share price of their shiny oil company when it goes public (which unfortunately will reflect in part the current price of oil). Nasty predicament. But they’re not nice people. Sympathy or schadenfreude worthless one way or t’other.

    Comment by Simple Simon — March 12, 2017 @ 10:35 am

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