Is Saudi winning or losing on oil?

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Is Saudi winning or losing on oil?

With no one cutting output, standoff might turn into a prolonged battle with uncertain results

By Shailesh Dash/Economic Beat

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Published: Tue 27 Oct 2015, 12:00 AM

Last updated: Wed 28 Oct 2015, 9:10 AM

A sharp drop in oil prices since June 2014 has turned the world's attention to Saudi Arabia's role in the oil market and the determinants of its oil policy. Initial hopes that the Saudi-led Organisation of the Petroleum Exporting Countries, or Opec, will come to the rescue and balance the price by curtailing its oil production were put to rest after the Opec's decision not to cut output in November 2014.
Instead, some Opec member states such as Saudi Arabia and Iraq increased production to record levels in a bid to defend their market share and to force higher cost-production facilities, especially in US shale oil, to shut down.
Consequently, global oil supply outstripped demand, with the Energy Information Administration, or EIA, reporting that the supply-demand imbalance reached 2.6 million barrels per day in the second quarter of 2015, compared to 0.8 mbpd in the same period last year.
This imbalance is expected to further aggravate with the upliftment of sanctions on Iran as the country is likely to boost oil output to make up for lost market share, equivalent to one mbpd, due to sanctions since 2012. From the demand side, lower expectations of global economic growth will raise concerns among oil exporters. Furthermore, fuel demand in the Middle East may also slow down, if the UAE's recent move to abolish subsidies is adopted by other GCC countries.
Moreover, demand from strategic stockpiling is also expected to ease next year as most countries have already augmented their crude oil inventories, leveraging the lower oil price environment. According to the EIA, OECD commercial oil inventories hit a record-high level of 2,876 million barrels in May 2015, roughly 300 million barrels more than a year ago.
The decision to maintain production levels was inspired by an oil supply glut - similar to what we are facing now - in the 1970-80s wherein Opec supply cuts resulted in its global market share falling from 48 per cent in 1970 to 30 per cent in 1985. It is clear that the Opec has learned from past mistakes and is unlikely to change its position, as stated by Saudi Oil Minister Ali Al Naimi: "Even $20 per barrel wouldn't trigger a change of heart".
Following the Opec's decision, US shale producers were initially confident and believed that they can endure such low prices on the back of operational efficiencies while Saudi Arabia and other Opec countries won't be able to withstand a long-term siege given their heavy dependence on oil revenues to finance government spending. Consequently, US shale output remained resilient despite a near-50 per cent reduction in the number of oil rigs, which was largely attributed to the closure/redundancy of inefficient rigs.
However, a recent report from the International Energy Agency, or IEA, suggests that US output has started declining in the past two months. The IEA data shows monthly contractions of 90,000 barrels a day in July and almost 200,000 barrels a day in August. Furthermore, the agency predicts that non-Opec production will drop by 500,000 barrels a day, including a 400,000-barrels-a-day reduction in US production of light tight oil in 2016. The IEA further went on saying "on the face of it, the Saudi-led Opec strategy to defend market share regardless of price appears to be having the intended effect of driving out costly, 'inefficient' production".
Although too early to call, but Saudi-led Opec seems to be gaining an edge; however, they are paying a heavy price for it. Given the heavy dependence of government revenues on oil, the kingdom is running through its foreign currency reserves faster than shale oil output is falling.
The Saudi Arabian Monetary Authority's reserves held in foreign securities have fallen about 10 per cent from a peak of $737 billion in August 2014 to $661 billion in July 2015. Moreover, the country also plans to raise debt worth $27 billion through bond issues by end of the 2015.
Other Opec members such as Algeria, Angola, Venezuela and Libya are also facing similar fiscal deficits; however, unlike Saudi Arabia, they do not have large financial reserves to sustain government spending in the mid-to-long term. Consequently, internal disputes over the Opec's position to maintain production levels have started to spill over.
Non-Opec oil exporters are equally battered by the oil market turmoil. For instance, Russia, the third-largest producer of oil, is experiencing the worst economic downturn in years, with its economy expected to shrink by 3.4 per cent this year on the back of low oil prices and Western sanctions imposed due to the crisis in Ukraine. Similarly, Canada's economy also shrank in the first half of 2015, putting the country in a modest recession. Major oil firms globally have reduced their spending and are delaying investments worth nearly $200 billion to deal with the oil slump.
Since nobody is ready to cut oil production, this standoff might turn into a prolonged battle with uncertain outcomes. US shale producers, with total debt of about $200 billion, will have no choice but to keep pumping in order to service these debts.
However, refinancing these debts in the mid-to-long term will get extremely difficult given shaky investor confidence, and the industry will move towards consolidation. From the Opec's perspective, Saudi Arabia will continue to tap foreign reserves or raise debt for government financing and is unlikely to waver from its position until the US shale production drops to levels acceptable to petro-states. Confrontational issues may aggravate, thereby fuelling regional instability. Non-Opec oil exporters will undoubtedly be the collateral damage.
Going forward, oil prices are expected to remain subdued in the near term and further downside on the back of the supply-demand imbalance cannot be ruled out. Moreover, even if the price of crude rebounds, the record level of inventories of most countries will delay the increase in prices, as these countries would first utilise cheaper stockpiles already in their storages. Therefore, while the near-term outlook on oil prices remain gloomy, increasing disputes between Opec members and/or incapacitation of oil infrastructure due to regional conflicts in Syria and Iraq, could surprise an upside for oil prices.
The writer is the founder and chief executive officer of Al Masah Capital Management. Views expressed are his own and do not reflect the newspaper's policy.


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