Is the Saudi Market Share Strategy Backfiring?

Yves here. Stocks around the world took a nosedive today, due to WTI sliding to under $30 a barrel, as well as disappointing earnings announcements from Chevron and BP, along with a warning from Standard & Poors.

But the bigger cause of the sour mood which apparently swept from oil stocks into the broader market, was that a rumored deal among Russia, Iran, and the Saudis is nowhere near as imminent as the hype of last week would have investors believe. And there’s an obvious reason why.

As we indicated last year, when Saudi Arabia embarked on its oil-price-cutting strategy, which is what refusing to reduce production to support prices amounted to, it looked like a masterstroke. It had several sets of opponents in its crosshairs. The firs was US frackers, who posed an intermediate-term threat if the shale boom and resulting government subsidies supported the construction of LNG transport facilities (which on a cold-blooded economic calculation are not justifiable given that under the old normal, shale production would have peaked around 2022 and started declining gradually, then more sharply around 2030, and that assumed no curbs due to earthquakes or water supply impact). Second was clean energy, which becomes much less attractive if conventional energy becomes cheap. Third was Saudi Arabia’s geopolitical opponents, most important Russia and iran.

Recall that the Western media went all in on the story of Russian vulnerability. In 2015, Europe tightened sanctions, and the Western leaders were in barely-veiled terms calling for regime change in Russia, on the premise that Putin could not survive the one-two punch of low oil prices and foreign sanction.

Here we are, in 2016, with barely an acknowledgment of that period. Not only did the Europeans overestimate Putin’s vulnerability, but the Saudis badly underestimated theirs.

It’s impossible to know what scenarios the Saudi officialdom ran, but it appears their downside case was not that much more dire than that of conventional wisdom as of early 2015: that oil prices would be low for the first half of 2015, and would recover to more or less their former level in the second half of the year. One has to think the Saudis allowed for some overshoot in terms of what then would have been seen as a dire scenario, say oil below $60 for nine months.

In other words, the Saudis simply did not anticipate that both government and private producers had the same incentives: to keep pumping because they needed the revenues so badly. And the deterioration of the Chinese economy and lousy fundamentals in Europe mean that low oil prices haven’t led to an upswing in consumption to offset the surplus supply.

And they further underestimated the staying power of some of those players. As John Dizard pointed out early on, US shale players would keep going as long as they had access to funding (and they also got adept about cost reduction, in cutting back at higher cost sites and increasing output at ones with better economics). And even though oil is an important export for Russia, it is far more diverse an economy than is widely understood and much closer to being an autarky than one-trick-pony Saudi Arabia.

So the severity and probable extended duration of low oil prices has blown back on Saudi Arabia in a very nasty way, particularly since its government and society have become very dependent on a high level of oil revenues.

Russia and Iran are thus able to exploit the fact that the Saudis are hoist on their own petard. They won’t do an oil deal unless they also get a deal on Syria. That is something the Saudis will find very hard to swallow. But all that Russia and Iran have to do is stand pat. The Saudis can’t take protracted budgetary hemorrhaging and they know that. But it may nevertheless take time for the Saudis to swallow their pride and make the necessary concessions (and figure out how to make them look like peace with honor). And the longer this impasse persists, the more Mr. Market will continue to fret.

By Michael McDonald, an assistant professor of finance and a consultant to companies regarding capital structure decisions and investments. Originally published at OilPrice

Much of the rout in oil prices has been predicated upon the staying power of Saudi Arabia and other OPEC producers. As oil prices have continued to fall, virtually all of OPEC has been pumping oil as fast as possible to generate increased revenues at lower prices. That practice has helped to fuel the oil glut and led to a price that would have been unthinkably low just a couple of years ago. Oil markets have been largely assuming that OPEC producers could go on producing at these levels for years, but what if that’s not the case?

Take the strongest of the OPEC producers, Saudi Arabia for instance. Saudi Arabia has very low cost per barrel of production – much lower than any shale producer in the U.S. But as a country, Saudi Arabia also has other significant obligations that it has to meet and oil revenues are effectively its only way of meeting these obligations. The same principle holds true for all other OPEC producers, though most are in worse shape than the Saudis. With oil at these prices, all of OPEC is bleeding fast. The oil revenues that the Saudis and others are bringing in are simply not enough to meet their on-going obligations. As a result, Saudi Arabia and others have been forced to turn to their savings – foreign currency reserves.

Saudi Arabia started 2015 with roughly $720B in reserves. By August it was down to $650B. As of December, Saudi Arabia has around $620B in reserves. If oil averages $20 a barrel going forward for the next couple of years, Saudi Arabia will be broke by mid-2018 even after accounting for its recent budget cuts that trimmed internal spending. $30 a barrel oil buys the country about 6 months, tiding it over to early 2019. Libya, Iraq, and Nigeria are all in much worse shape, as of course is Venezuela.

Even before Saudi Arabia gets to the point of bankruptcy though, panic may begin to set in for OPEC. Saudi Arabia is the most stable member of OPEC, and other than its rival Iran, who is use to budgetary pressure, the rest of OPEC is largely bloated and ill-prepared for a long period of low oil prices.

Saudi Arabia will likely end 2016 with around $450B in reserves, and other OPEC members will be in much worse shape. With reserves that low, many OPEC members may be forced to turn to the bond markets. Unfortunately for OPEC, the interest rate environment around the world is starting to tighten and bond rates will likely be higher by the end of this year. Add to that the continuing uncertainty around oil prices, and some countries may find bond market access very difficult. Even the Saudis may find that their financial strain is causing concern among bond investors.

There is reason to think that the price of oil will remain subdued for a long time to come if the Saudis have anything to say about the matter. In particular, the Kingdom is concerned about the rest of the world switching to other forms of energy sources, and sees low oil prices as a way to delay the adoption of substitute forms of energy. It’s a wise long-term plan.

But even the Saudis don’t want to see oil prices this low, nor can they afford a prolonged period of oil prices below $50 a barrel. To say that oil is crucial to Saudi Arabia is an understatement; oil is to Saudi Arabia what gambling is to Las Vegas. The Saudi’s cannot withstand low oil prices forever, and if drastic changes don’t happen, then within two years, the world’s largest oil producer maybe facing very hard times.

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  1. PlutoniumKun

    There is something rather pleasurable in seeing the Saudi’s hoist on their own petard. Just a few fairly random thoughts on this.

    First thing – I don’t think there is any evidence that the Saudi’s planned this as a deliberate strategy. I think it is far more likely that the sudden drop in prices occurred due to a surge of new production coming on stream to profit from high prices. I think the Saudi response was opportunistic – they saw the panic among frackers, Russians, Iranians and thought to themselves ‘hey, maybe we can use this to our advantage…’.

    Second, I think the issue of ‘market share’ is exaggerated. I don’t think that having a high percentage of market share is a core Saudi concern. What is important is their geopolitical role as market makers and the grossly outsized power this gives them over the West, in particular. It is this role which has allowed them to, for example, influence US elections by lowering or raising prices at particular times (does anyone really think they never had discussions about this with the Royal Families good friends the Bushes?). In this sense, their main concern has been fracking/oil sands – a US self sufficient in oil along with a European/Russian long term arrangement would sap the Saudi’s powers, even if they stayed rich by selling to the rest of the world. This is what they most wanted to stop. Its not the size of their market that concerns them, it is who is dependent upon them.

    Third, I think its an exaggeration to say that they have concerns about the LNG market and renewables. Renewable energy investment is overwhelmingly invested in electricity generation, and very little electric power comes from oil. It is coal and nuclear which is in a death fight with renewables. Even with widespread electrification of transport, etc., there would still be a substantial demand for oil, and as the Saudi’s have the cheapest to produce oil in the world, they would take any market that existed – and I know of no likely scenario where world demand would reduce to below 10 million barrels a day (roundabout what the Saudi’s produce). So renewables are only a threat in the longer term, not short to medium.

    I would also note that LNG is an inherently expensive form of energy, only viable at high energy prices. I don’t think the Saudi’s ever saw US LNG as a significant competitor.

    On a final note about SA, as any War Nerd reader will know, there has long been more instability within Saudi Arabia than most people think, mostly because the media for some strange reason rarely report on it. So its easy to exaggerate the impact of current problems with the Shia minority (who are probably a much bigger minority than the Saudi’s would ever admit). But they are probably capable through sheer brutality if nothing else, of keeping control, and keeping Isis at bay as well. But regimes like the Saudi’s can often appear very strong, and then suddenly…. everything disintegrates. All it takes is a botched succession, and various power groups inside and outside seeing a chance. Its not impossible that it could collapse with startling speed, such is the way with regimes like that.

    1. visitor

      I don’t think that having a high percentage of market share is a core Saudi concern.

      You are of course right. The strategy of Saudi Arabia has always been to be the swing producer, the one that can tip the scales of the market towards low-price/abundance, or high-price/scarcity, via marginal variations in the extraction rate of oil (a few hundreds of thousands to a couple million barrels per day).

      This position is jeopardized with tar sands from Canada, shale oil in the USA, new African and Brazilian off-shore fields (all three sources expensive ones), and the re-entry of Iran into the market.

      there has long been more instability within Saudi Arabia than most people think.

      I wonder what is happening with the other Gulf states — monarchies with political and economic structures comparable to those of Saudi Arabia. They are of course dominated by Saudi Arabia, but how long will they, for instance, be willing to participate in costly endeavours like the war in Yemen? And what about internal social peace in the face of budgetary stress?

      1. aet

        Anthropogenic climate change will render that entire area – the Persian Gulf littoral – uninhabitable by humans without artificial environments within 75 years, and large areas of built Florida will also by then be under water: and people only started to burn oil and nat gas for power less than one hundred and seventy-five years ago.

        Oil costs us too much to use, even were its price zero as like the air you breathe. The indirect harms arising from its use are greater than the direct benefits arising from its use. It’s that simple.

        1. Synoia

          and large areas of built Florida will also by then be under water

          200,000,000 Americans live near coasts. The biggest threat to them from Rising sea levels is the loss of Coastal Infrastructure, Sewage Plants, Roads, Power Stations and Docks.

      2. PlutoniumKun

        I wonder what is happening with the other Gulf states — monarchies with political and economic structures comparable to those of Saudi Arabia. They are of course dominated by Saudi Arabia, but how long will they, for instance, be willing to participate in costly endeavours like the war in Yemen? And what about internal social peace in the face of budgetary stress?

        I’m no expert, but I think that while the monarchies there are very secure, most of them have very big Shia populations – especially Bahrain. The real fear they have is a Shia surge which could set off civil disturbances which could lead to the collapse of the cosy system they’ve set up. The Gulf States I think are in a potentially unstable situation because the rich in those countries have their boltholes in Switzerland and the Riviera. Its not like the Assads or Gaddafi who would fight to the death for power because they have no choice. The pampered royalty of the region would hop on their private jets rather than grab a gun. So in the event of things going wrong, I think things could collapse much more rapidly than outer appearances of stability would suggest.

        1. Rajesh

          They have witnessed first hand the swift downfall of the Shah and I think they would be careful to avoid the situation and perhaps a Shia surge will have the opposite effect. It may make them even stronger…the presence of an enemy usually tends to unite people to obeying a ‘higher authority’

    1. J

      It always made my head explode when people would talk about $50/barrel oil as “cheap oil”. That’d be 20-30% above historical prices.

  2. Wyoming

    Really now. There is nothing in this analysis which is even slightly new or original. Right from the beginning this scenario was a significant possibility to those who understand how this business is funded. Desperate people find ways to survive…until they can’t. While the Saudis may have underestimated how long it would take to crush the fracking/tar sands industries there is no doubt that they know this business well and knew they were kicking off an economic war – from a position of strength not weakness. And they are winning and there is not much reason to think they are going to lose. Their budget situation will recover much more quickly when this little war winds down than the than the fracking industry will rebuild itself. And if a few countries like Venezuela, Nigeria, Canada and Iraq get permanently damaged – well why should they care.

  3. Steve H.

    Help me here, this has got to be ignorance on my part but…

    There appear to be structural changes happening in the balance of power, and available resources are worth more than QE-inflated dollars. Umkehren: a dollar is only worth what you can get for it, while oil is the defacto currency currently.

    This allows that the oil that Saudi Arabia, Iran and Russia has is worth more in the future, and the coal China has is similarly future energy available. Also that the vast space of Russia is a resource, for military depth, pipelines, and potential arability.

    Politically, the Shanghai Cooperation Organization, with a financial arm of the BRICS bank, is a genuine alternative to NATO and the western MIT-elite central banking system. How much pixie dust is left in the Wand of Fiat? I’m a prior bear on this, and am surprised at how expansive the froth of bubbles has been. But for the machine-minds out there, a gallon of oil has tangible value, while the price of a dollar is subject to the whims of men.

    So, my question is, why not just burn through the foreign reserves while they can still buy something, maintaining internal order while the rest of the world sorts things out?

    1. craazyboy

      For Saudi, $30 oil is still quite profitable. Therefore, if they stopped pumping they would burn thru foreign reserves very fast.

      The BRICs and other like minded countries are trying to get out from under the thumb of western banking and the current international order. So part of the process is making bi-lateral trade agreements which necessarily include their central banks stocking the other participants currency. But there is quite a bit of concern among the participants that the other guy(it’s always the other guy) may take advantage and print up huge amounts of “sovereign currency” and buy the fruits of their hard work and valuable natural resources with fiat funny muny. Or they may do it to devalue the currency so they can employ more domestic serfs. It’s hard to be sure of the reasons. haha. So there’s that again. Seems like no one really believes creating funny muny by entering numbers with a keyboard into a computer accounting ledger is really worth anything.

      Then the traditional western trade block represented by dollars/euro/yen (all pretty much fungible) still produce much industrial/technology/medical/intellectual property not found in the BRICS and others. Tho China is coming on strong in industrial areas and India in software and generic drugs. Brazil makes Embraer airplanes. So for the very long foreseeable future, I think we’ll just get some shift away in the volume of trade in reserve currencies, but they will be around for a while yet. Until Mad Max shows up.

      1. Steve H.

        Okay, so for now the West has the nice things. But also a documented history of adding zeroes in the plus column. OTO, no BRICS/Sunni alliances to see.

        What I get, then, is that current alliances will hold. But for how long? You write ‘for the very long foreseeable future’ while I can’t forsee ten years from now.

        But that’s my priors showing.

        1. craazyboy

          I’m not always sure I can see tomorrow, but then again the big gears of the world turn very slowly and the inertia seems massive.

          So far, adding zeros has worked great for us. The rest of the world needs them to buy stuff, and then buy our guv debt with their surpluses. But this situation is what makes some of the lesser countries either nervous or envious. Plus it’s much easier to enforce the current world order when your banking system has everyone’s money, and could block conventional trade at will should they decide you need “embargoing”.

      2. Yves Smith Post author

        It’s profitable on a cost basis. But their break-even to meet their budget needs is $90 a barrel. This was pretty well documented when oil prices started falling. Moodys and other analysts who were then pretty sanguine on the Saudis’ staying power used that figure.

        What has changed in 11 years is:

        1. Cost of meddling in the rest of the MIddle East

        2. Cost of buying off the local population.

        1. craazyboy

          Right. Actually I think I remember a $80 oil figure to meet the Saudi budget needs (welfare-warfare-police state) going back more than 5 years ago. But Steve’s question seemed to be why not leave the oil in the ground and spend all the reserves instead. So even at $30 it is a positive budget contribution, and without it the “2 year reserve life” would decrease. If someone should be motivated to leave it in the ground, it would be $60 cost frackers in the US, except they would go out of biz from the debt load and the dormant assets would get picked up by someone on the cheap and mothballed for future years.

    2. hidflect

      There is a rumour that America is following a strategic plan known as “use their’s first” whereby the Arabic countries are gradually drained of their oil and at that point the US untaps reserves near Prudhoe Bay that are allegedly as large (or larger than) the Saudi’s oilfields ever were thus re-establishing the US firmly as global, economic kingmaker. If true, it would explain Cheney’s cryptic pronouncement that “deficits don’t matter” some years ago.

      1. Steve H.

        Plausible. If so, that would mean the Saudi’s are following a ‘get it now’ strategy and won’t stop pumping so as to suppress the competition.

        Also, does this mean that MMT only holds up practically while the U.S. holds military dominance? Lordie.

      2. Harry

        Nothing cryptic about it. For the US deficits don’t matter. They only matter for the little countries.

      3. Synapsid


        Do you have a source for the statement about reserves near Prudhoe Bay that are allegedly as large as or larger than the Saudi oilfields ever were?

        This is new to me.

    1. ewmayer

      Interestingly the word petard derives from the French verb for ‘to break wind’ – I’ve been hoist by a few of those myself, especially after eating Mexican. ‘I fart in your general direction,’ quoth the taunting French knight.

  4. Oil Dusk

    As I watch oil stocks in my portfolio slide into bankruptcy, there is little doubt that the oil and gas assets of these companies will be either be sold to other companies that can develop them, the debt holders will recapitalize the companies and they will emerge from bankruptcy with a stronger balance sheet, or some other company will absorb this company along with all its assets. The common feature in all these scenarios is that even though a bunch of equity investors are out of luck in this country, the viable oil shale reservoirs will be developed as soon as the oil price allows. The U.S. oil shale and tight sands industry is a target that has not been taken out through these global antics.

    Even so, a lot of sweet spots in these oil shale plays are getting drilled in the current low price oil environment. There is also a finite limit of reserves economically available for oil shale plays that can be developed in the U.S. OPEC still holds the same trump card they held before they dropped the price – serious long term reserves that will supply much of the world’s oil going forward.

    The real target seems to have been all the large scale and long term (more than five years of development required) conventional reservoirs where those projects have now been postponed indefinitely. More than $320 billion of capital has not been invested that was previously programmed for oil and gas projects. When the bungee cord of supply bounces back in the next few years, and all the stored oil gets absorbed, prices could soar.

  5. susan the other

    The Saudis are taking Aramco public (still?) – all except for its big asset which is the oil reservoir. So does this mean Aramco is less profitable and a drag on their budget? Or that AR and AM are cutting ties? The Saudis claim their extraction costs are minimal now, won’t they go up if SA divests its Aramco shares? Don’t get that part. Also another mystery: that almost trillion-$ gift to Malaysia. What could be worth that? And then their pogrom on Yemen seems pretty stupid but I’m sure there are other reasons besides hating all friends of Iran that make the Saudis tick. No matter how you turn it they have a desperate situation. Because global warming. Maybe we are looking at the early logistics of a Saudi diaspora. It’s possible.

  6. Craig Rachel

    Why did the Saudis pick last year to crash crude prices and pump us into a recession if frackers and clean energy were their 1st & 2nd targets? It was clear 5 years ago what was happening with US tight shale. Clean energy growth was already slowing. It’s going to take another 25 years for it to double capacity to 10%, and that’s electricity. Cars that are more gas efficient cut their bottom line way more than windmills & solar panels.

    The timeline points to the deal between US & the Saudi’s geopolitical opponent Iran as the catalyst.

  7. curlydan

    My problem with shale plays is that the profitable price actually is subsidized by a weak regulatory environment. Fracking is definitely causing earthquakes and almost certainly is causing issues with water systems. The culpability of the frackers has not been addressed. At some point, a fracking disaster that the public will no longer tolerate will lead to better regulation and will weaken the subsidy. But longer-term subsidies (e.g. the hidden cost to the environment from fracking and tar sands via global warming) will remain, so I agree with you that the oil is coming out of the ground eventually once supply and demand stabilize even though the future profitable price may be higher than today’s price.

    1. Craig Rachel

      Fracking is 60 years old and fracking as we know it today is about 12. When do you think this disaster is going to come?

  8. TimmyB

    The Saudis picked an awful time to start a war by invading Yemen. The war only compounds the government’s economic problems. Body bags coming home don’t help domestic stability either. From what I read, the Saudi forces are poorly lead and are in a stalemate These facts, once they become well known, can only cause people to lose faith in the government. Same as WWI eventually brought down the Romanoffs, this war might bring down the House of Saud.

  9. RBHoughton

    The comments are all about Saud so I’ll respond to Yves’ mention of Russian autarky – its something we have encouraged for 70 years.

    I recall we supplied a shipment of defective gas pipes that blew-up as soon as the gas flowed through them. Newt Gingrich found it so amusing he made a joke about it to a jewish club in New York.

    Since then we have had one or another form of sanctions either on types of goods or on individual people.

    How can we feel any degree of surprise to find the country has made itself self-sufficient in necessaries. They know they cannot rely on us so they are forced to make it themselves or trade with like-minded others.

    If we don’t like a country why not simply cut them, have nothing to do with them. We invent our own rockets to service the ISS and anything else we rely on Russia to do for us. Alternatively, we talk through our ideological differences, recognise that Asia will not put money over society, and find some way of co-existing.

  10. Cry Shop

    One other point the Saudis missed. The banks have no incentive to start pulling in loans or forcing fracking/sand companies to go to the wall if the end result is a massive write off. Rather it’s much cheaper for the banks to go to the Fed and let it ride, all the while the bank managers keep collecting their salary, plus extra bonuses every time they roll it all over into a new loan package. For similar reasons, executives of the fracking/sand oil companies have no incentive to stop pumping, nor do the shareholders have any incentive to call their shares worthless. The only people getting screwed now are the people who are the ultimate lenders to the Fed. Unless someone like Bernie gets in office, interest rates are going no where. There is too much political money to insure it won’t happen. :-9

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