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With the OPEC decision to cut oil production, for the first time in 8 years, by 1.2m barrels a day to 32.5m barrels per day, Saudi Arabia has raised the white flag and admitted defeat in its attempt to regain control of the global oil market. If the cut in production holds it should bring global oil and supply back into balance and enable crude oil prices to settle in well above $50 per barrel. But let’s be clear it will be a hollow victory for Saudi Arabia as the decision will likely give control of the global oil market back to the United States and it will also cap oil prices going forward.
It all started in early October 2014 when Saudi officials began to brief analysts and traders not to expect oil production reductions. Saudi Arabia then blocked calls from OPEC member to cut production and then came the decision at the OPEC November 2014 meeting to roll over on the ceiling of 30 million barrels of day of production. This took the oil market by great surprise as all market participants were used to thirty years of Saudi Arabia being the central banker to the global oil world. Saudi kept everything in check. When prices were too high they would increase production. When there was too much oil in the market they would reduce production and they used their power within OPEC to ensure that others followed suit.
There have been lots of theories as to why Saudi decided to do this including that they were politically motivated against the growing power of Iran in the Gulf region. But the reality is that it was all about economics and long term positioning on the global oil market. OPEC has been losing market share for years and Saudi Arabia lost its position as the world’s no. 1 producer of oil some years back and this has happened in a very short period of time. In 2011, Saudi was the world’s largest producer of oil and oil liquids. It is now behind Russia and in-line with the United States.
And the rise of the United States as an oil producer has been nothing short of remarkable. In 2011, US oil and oil liquids production was 7.8m barrels a day. Last year it was over 60% higher at 12.8m barrels. This has all happened because of advances in drilling technology and access to cheap capital from the US capital markets. To make matters worse for Saudi Arabia, demand growth has been much weaker than many oil market participants anticipated and with growing momentum around the electrification of the automobile oil demand growth is likely to remain weak and at some point it may even peak over the next decade. It was against this background that Saudi Arabia decided to flex its muscles and try to force out higher costs producers out of the market including US shale producers in order to retain control of the global oil market
However, this strategy has failed. There are a numbers of reasons for this, the most important of which is that many oil producers had oil hedges in place which have enabled them to generate positive cash flows even though their production costs (and sometimes variable costs) have been higher than recent oil prices. In addition, there is a deeply entrenched view among oil companies that the oil fall is only temporary and that prices will rise again. This is supported by a similar view by many in the capital markets who have continued to finance these oil companies.
And yes, oil production in the United States will drop this year for the first time since 2008 thanks to the low oil prices but by only 0.5m barrels per day. And more worryingly for Saudi Arabia, massive competition in the US industry continues to not only push oil extraction costs lower but also shorten development times. Add to that a pro-oil industry Donald Trump led new US government and a liquid capital market and what this means is that any sustainable oil price rise will be met with very quick increases in increases in oil production. What this also means is that US oil production will keep global oil prices upper bound at maximum $70 over the coming years. And the other consequence is that the global oil world is, as it was for much of the 20th century, again under the control of the United States.