Saudi Cut In Oil Price for US May Lead To Price War

Yves here. We pointed out last month that the US was on the list of Saudi targets when it made clear it was not supporting oil prices at a level higher than $80 a barrel. Some readers rejected the idea that Riyadh would launch a price war to undermine the US, when in fact the desert kingdom has been mightily unhappy with US policies in the Middle East for some time (in case you managed to miss it, ISIS started out as Prince Bandar’s private army and odds are high that it continues to get Saudi support).

A major news story today, that the Saudis are letting oil prices drop further, provides more support for our jaundiced assessment last month. As we wrote then:

It is critical to remember that the Saudis have no compunction about imposing costs on other nations to maximize the value of their oil resource long term and hence the power they derive from it. The 1970s oil shock produced a nasty recession in the US and most other advanced economies and gave a further impetus to inflation, which was already hard to manage and dampened growth by discouraging investment.

The current alignment of factors gives the Saudis the opportunity to make life miserable for a long list of parties they would like to discipline, including the US.

The sharp rise in the dollar means that lowering the price of oil in dollar terms is unlikely to leave the desert kingdom worse off in local currency terms. But it undermines US energy development, both fracking and development in the Bakken, as well as more development by the majors, who were regularly criticized by analysts for how much they were spending on exploration when the math didn’t pencil out well at over $100 a barrel. Countries whose oil is output is mainly heavy, sour crude, like Iran and Venezuela, find it hard to sell their oil when prices are below $100 a barrel (or at least when the dollar was weaker, but the $80 price point, even with a strong dollar, may be low enough to cause discomfort).

In other words, this is a classic case of predatory pricing: set your price low enough long enough to do real damage to competitors, and reduce their market share, not just immediately, but in the middle to long term.

Now admittedly some pet targets may not be hurt as badly as hoped. Russia will suffer more of an opportunity loss than an actual cost from the price reduction, since the ruble has fallen significantly against the dollar. The Saudis may hope to partially displace Russia as a supplier of oil to Europe (now roughly 1/3 of the total) but refineries would need to be retooled to refine the Saudi’s light crude, so it isn’t clear whether even what amounts to bargain prices will offset this cost (and readers point out that Russian crude may also produced a better mix of distillates for European use, since they are much heavier users of diesel fuel than the US).

But aside from the not-inconsiderable economic impact, the surprise Saudi step looks to be an even bigger geopolitical winner. The US and Riyadh have been at odds for over a year; the Saudis were particularly unhappy over the US failure to try to topple Assad last summer (you may recall the intensity of the Administration warmongering versus the dubious US interest; even Congress showed an unexpected amount of backbone and made its lack of support for Syrian adventurism clear). The Saudis have also long been less than happy with the US refusal to attack Iran (which is a rare case of the US acting as a responsible hegemon and curbing a putative ally with a bad case of blood lust). That unhappiness has ben compounded by the US now effectively helping the Assad regime and working in as distanced a manner as possible with Iran in targeting ISIS.

These parts of Marcy Wheeler’s analysis are spot on:

Cutting prices will make it far harder for Iraq’s Shia led government to invest in the fight against ISIL. So long as Western sanctions continue, it will destabilize Iran significantly, not only making it a lot harder for Iran to help Iraq and Syria, but also undermining the government that has chosen to deal with the US. The cuts will also destabilize Iran’s allies in Venezuela and Ecuador. Oligarchic forces have been trying to foment a coup in the former country for some time and this may well help to do so…The Saudis have been trying to undercut Russia for some time and — to the extent the ruble exchange with the dollar doesn’t shelter Russia from these changes [Update: though see Mark Adomanis on how this is hurting Russian consumers] — this price cut will hurt Russia too.

Ultimately, though, I suspect the US is just as much the target of this move as Iran and Russia are. Since the US refused to take out Assad last year and inched forward with its Iran deal, the Saudis have been worried about having Shia Iran and Iraq take over its role as the swing producer in the world, mirroring what happened in 1976 when the US replaced Iran’s Shah with the Saudis. By destabilizing the government in negotiations with the US, the price cut will make it a lot harder to achieve such a deal.

Just as importantly, the US is now a petro-state. And this price cut will make fracking (and deepwater drilling) unprofitable. We’ve been fracking largely to give ourselves some breathing room from the Saudis; cutting the price will make it far harder for us to sustain that effort (and will make some renewables uncompetitive).

To me, then, this move looks like part of an effort to force the outcome the Saudis have been chasing for a decade and even more aggressively since the Arab Spring: to paralyze Shia governments just as the chaos of ISIL threatens to remap the Middle East.

The Saudis may well claim to be supporting our fight against ISIL, but the long-term commitment to dropping oil prices, looks more like an effort to undercut it.

With that as background, OilPrice reports on the latest skirmish in the oil price war.

By Andy Tully, a news editor at OilPrice. Originally published at OilPrice

Saudi Arabia’s move to cut the cost of its oil to US customers has injected fear into the oil markets, bringing the price of OPEC crude below $80 and suggesting to some observers that the cartel is preparing for a global price war.

OPEC production has remained level despite worldwide demand, and as a result, on Nov. 5, the cartel reported that its basket price – the average price of its leading grades of crude oil – had dropped to $78.67 a barrel the day before, the lowest in about four years. And US production has reached its highest level in more than three decades, creating a buyer’s market for oil.

Saudi Arabia cut its price for US customers on Nov. 3. Meanwhile, along with Saudi Arabia, Iraq and Iran, two other major OPEC producers, also are cutting prices to Asian customers this month.

The reason for the Saudi move is a matter of some dispute. Some observers of the global oil market view the Saudi price cut to US customers as an effort to undermine the boom in American production of oil from shale.

“The market reacted to it very negatively, thinking, ‘Here we go, we’re going to have a price war in the United States,’ ” Anthony Lerner, a senior vice president of industrial commodities at brokerage R.J. O’Brien & Associates LLC, told The Wall Street Journal.

But another person familiar with the Saudi decision, whose name was not disclosed, told the newspaper that the aim was merely to lure US refiners to buy cheaper oil from Saudi Arabia and thus increase their profits.

Whatever the Saudi motivation, industry insiders and observers from OPEC officials to oil price news services view these actions as leading to a price war. In Baghdad, for example, Iraqi Oil Minister Adel Abdul Mahdi told parliament on Oct. 30 that the struggle is internal in OPEC, with members fighting one another to hold on to their shares of the petroleum market.

Meanwhile, the Oil Price Information Service (OPIS), which reports extensively on the oil trade, said in a Nov. 4 report that the Saudi move had caused a “panic” in the market.

“Global traders are in essence voting on a referendum as to whether they believe that a price war is looming among OPEC and non-OPEC producers,” the OPIS reported, according to The New York Times, “and for the moment, they are casting a ‘yes’ vote for the conflict.”

As frightening, or at least chaotic, as all this may sound, however, there are positive signs.

AAA, the US auto club, said Nov. 4 that the national average for regular gasoline had fallen to $2.97, down 6 cents from the previous week and 33 cents from the same date in October. And industrial customers including hotels, restaurants, railroads and airlines also are likely to benefit from lower fuel costs.

For now, the only losers are the oil and natural gas industries. They’ve been enjoying a kind of windfall in the past few years as they’ve increased exploration and production of shale oil. Now, though, their share prices are falling for fear that their profits will begin eroding.

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  1. abynormal

    out of my league here…wouldn’t bond maturities benefit? i ask b/c blackrock’s been yakking reforms (too suspect) and lawd knows the fed balance sheet could use the help.

    Dec 2014 Debt Maturities
    General Electric Co. $35 billion
    JPMorgan Chase & Co. $28 billion
    Bank of America Corp. $27 billion
    Citigroup Inc. $22 billion
    Morgan Stanley $20 billion
    Goldman Sachs Group Inc. $20 billion
    Wells Fargo & Co. $9.5 billion
    MetLife Inc. $7.4 billion
    Caterpillar Inc. $6.7 billion
    Procter & Gamble Co. $6 billion

  2. Peppsi

    I think a lot of us are more than happy to see fracking chopped down to size. I wonder this will affect all the banks who finance it. Though I’m sorry for the Iraqis, Iranians, Russians, and Venezuelans who’ll suffer.

    1. Chris

      Yes, the $10,000 question is who is holding the bag on all that junk debt written to the shale/fracking companies that will likely default in 2015-2017.

      I have no research to back this up, but my guess is that it is largely held by hedge funds and pension funds, with fallout somewhat muted compared to the sub-prime crisis of 2007-09.

  3. beene

    It’s great for consumers on the budget plus delays corporations of destroying ground water supplies in the USA.

    I read a some years ago the alternatives like wind and solar could not compete below 50 dollars a barrel. So we have more time to develop alternatives that do not destroy our environment.

  4. Emad Mostaque

    But Saudi exports have been collapsing this year and the oil price cuts were from record high levels with current OSPs still well above average, you can see charts here: (also a bonus on the great commodity index heist in there)

    This is an instance where the basic facts are completely opposite to the popular story, quite remarkable

    1. jesse

      Indeed – the Oil Price article Yves posted a few days ago in the links was a good cut up of the “cheap oil” commentary. It pointed put oil was $10/barrel a decade ago – so we’re still at a 700% increase.

  5. Paul Tioxon

    Amazingly enough, the benefits of a price drop causing panic, disarray and general gloom and doom couldn’t be better for the 99%. The power of the Saudi’s to inflict damage on their competitors inflicts an increase in disposable dollars for Nascar Ned and Suzi Creamcheese. And while this is a finance blog, figuring out the calculus of money grubbing is the platform that leads to other interesting political discussions, at the end of the day, the bottom line is more money in everyone’s wallet that consumes at the gas station or buys from industries with energy costs front and center, such as air travel and leisure travel via auto. The Geo-political war for market share is not going to make me pick up the phone and scream at my Congressperson to go to war against Iran, Syria and everyone else that’s chopping off heads because I now have more money and gas prices keep lowering week by week. This experience in power politics is having the exact opposite effect on average Americans in their everyday lives. The comforting fact of lower gas prices is causing pick up truck and over-sized SUV sales to hit double digits increases in the past month. Conversely, electric vehicles such as the Nissan Leaf and Ford C-Max are down in sales and up in sales incentives to goose buying.

    So, the unintended consequences for price wars is not to hurt the American People this time around, but to hurt American Energy companies and the Government’s standing policies to protect and subsidize them. And I might add, this is a call for more subsidies to solar, wind and electric plug vehicle ownership, not a time to repeat the skewed logic of the price from market based economics, when the game has been rigged for so long. The only rational course is to be guided by policy, not price and to subsidize price for the expansion and wide adoption of solar energy production and consumer products using electricity, not fossil fuels. If market based economics has been so thoroughly debunked here on every occasion possible, why even bother with any repetition of the Big Fossil Energy PR work and state the policy of calling for expanded subsidies for solar? Why even the tiniest hand wringing of negative un-competitiveness of sustainable in the face of falling prices for fossil fuels? Geo-PetroPolitiks is not going away, and a decade or 2 from now will return as needed from OPEC, with damaging consequences returning to our everyday lives. We need a steady policy for sustainables to counter the uncertainty of market prices.

    1. different clue

      But if one of Saudi Arabia’s long-term goals is to exterminate as much future renewables-development in America as they can, then their spokesfolk and feltrav-symps will take this opportunity to de-subsidize renewables the rest of the way so as to help get them exterminated. Also they will work to exterminate car-mileage efficiency requirements and they will work to keep gas undertaxed.

      1. Paul Tioxon

        Well, then, we’ll just redouble our efforts and take the apropriate political counter measures, and re-re subsidize and destroy them right back!

        No Pasran!

  6. Chauncey Gardiner

    A reassessment and national conversation about our relationship with the House of Saud is long past its pull date. Although the price cuts are enticing in the short-term, and may indeed be pivotal to elevating the world out of a deflationary spiral, the leverage it gives them to continue to influence U.S. policy in the M.E. is detrimental to the long-term interests of the American people and others in the region IMO.

  7. Gil Gamseh

    It’s clear that US lawmakers will simply have to increase subsidies for shale oil producers. E.g., all of their costs, and a guaranteed profit. The USA must, in no way shape or form, be deterred from causing Climate Catastrophe. Because, well, that’s why God made us.

  8. susan the other

    Interesting aside, above, about the Saudis possibly reducing the price of crude to attract US majors because they can make a good profit. Still, it’s at the expense of shale and sand development which the majors are involved in. It would stand to reason that Keystone is now dead. We can only hope. I will never believe (without extraordinary evidence) that the Saudis have made a break with us. I will always believe we are in cahoots.

  9. different clue

    If this Saudi pricecutting leads to the long-term off-lining and shutting-in of unconventional oil all over the world followed by eventual Saudi price-restoration or even price-rises, the reduction of carbon-skydumping will be a good long-term result.

  10. Stelios Theoharidis

    Didn’t the Saudis directly threaten the Russians some time ago over their intransigence on the Syria issue? The Russian economy seems to depend more on fossil fuel exports than the US. I wouldn’t be surprised if they were the direct target and the others were the collateral damage. However, strategically it seems like a win-win for the Saudis to push prices down at this juncture, assuming that they can damage their competitors. Assuming that there will be a cascade of failing shale gas firms, someone will pick up the pieces. There is an inherent flexibility. If someone else can get the production assets below the cost of installation, then the return on investment equation changes, and they can go back to production at a lower acceptable cost. I’m sure there are quite a few players in the resource business with excess capital to play with. Its pretty apparent when coal is considered. As natural gas prices declined precipitously in the US, many of the energy production facilities switched to being gas fired from coal fired. Now coal producers didn’t shut down, but while US consumption has declined significantly, the coal producers moved to exporting coal to China.

    1. hunkerdown

      Bandar did more or less use the “Nice Olympics you got there” line on them. To what extent he speaks for the House of Saud or Aramco these days is open to debate.

  11. Fiver

    I note the Atlantic now has a piece claiming ISIS is a covert Saudi operation. That in itself ought to say plenty to people familiar with that publication’s agenda.

    I do not buy the explanation that there is a huge rift in US/Saudi relations. Cutting prices to US (and global) consumers by 20%-30% is one funny way to ‘punish’ a political ‘foe’ – I’d think the Saudis would’ve worked with OPEC to squeeze supply for higher prices if ‘pain’ was the aim. I think we need to back up and look at what happened to oil prices at the end of prior QE’s and what the particular global supply and demand features were at those time(s). We’ve had 2 major rattles in bond and equity markets surrounding the ‘end’ of QE. The first one resonated with this piece in Forbes back in June, predicting just such a large pull-back in prices due to a number of factors, none of which involved Saudi machinations:

    As it turned out, the ‘uncertainty’ (for outsiders) as to QE’s confirmed demise delayed the reckoning for some time, but as China, Europe, Japan and others clearly weakened while the US rode ‘better than expected’ (because heavily padded, in my opinion) data, the market became more and more convinced QE would indeed ‘end’ – at least temporarily. I rather suspect the actual ‘trigger’ for the very brief, reversed-by-Fed, phantom correction recently experienced was, of all things, the run on PIMCO after Gross announced his departure, and the fact Russia and others started paying down big amounts of foreign debt in dollars. Be that as it may, the market was more than ready to off-load the entire QE premium in the face of withering global demand and the apparent end of QE. That this hurts a bunch of current US enemies is not a coincidence, but a feature of how various aspects of US policy tend to dovetail – that is, after all, what policy planning is all about.

    The only way I can see a real rift in the US/Saudi relationship is when Saudi production goes into serious decline, or when Iran is considered by neocons and their allies completely ‘contained’ or neutralized (it has been in real terms for years in the eyes of the sane) and the last Arab/Muslim power standing, i.e., Saudi Arabia, finds itself in the crosshairs. So far as the shale oil boom is concerned, the lower prices actually do the US a favor, and limit both the speculative and environmental damage wreaked by so very short-sighted and temporary a ‘bonanza’.

    1. different clue

      Lowering oil prices to attack America now is no funnier than KSA lowering oil prices to undermine Soviet economy during the Reagan period. It is designed among other things to shut down as much unconventional production all over the world as possible to leave KSA and other OPECkers in position to raise oil price to new heights once unconventional production is too gone to price-pressure it downward. It is also designed to shrink back “alternative” energy production and “alternative energy deconsumption” . . . as in major mass-transit restoration, a Nixon-style national speed limit to lower fuel-use per mile driven, etc.

      The driveaholics will enjoy the low prices while they last, and then start suffering when their favorite drink becomes semi-unaffordable.

      1. Fiver

        I would just point out that nobody at the time – and I mean nobody – talked about lower oil prices as a weapon to use against the USSR. The ‘oil weapon’ is in my view just one of the myths created after-the-fact to try to make it appear the US (in particular, Reaganites/Republicans) and its allies (Saudis) had executed a first-order strategic coup de grace. However, as even this little Wiki entry suffices to convey, the problem was a glut in supply and a dive in demand – the same thing we see now.

        I’m not saying low oil prices did not hurt the former Soviet Union – so did Reagan’s insane military build-up (which the USSR should’ve ignored, it being 100% overkill). But the key elements were the truly revolutionary developments in computers and the huge productivity gains entailed which the Soviets were effectively shut out from, and most important, the changes in mass culture within the USSR itself – their version of the ’60’s.

        I’ve long argued US/Saudi policy since oil became so financialized and as US oil production began to rise again was one of suppressing oil production elsewhere (Libya, Iran, Iraq foremost) to keep prices high, and it worked throughout the QE period. Had the US NOT so gratuitously and (via mercenary proxy) brutishly gone after Syria, Russia’s only regional ally, leading to Putin’s so-called ‘intransigence’ vis a vis Syria, then directly to the US-orchestrated coup in Ukraine, sanctions, another European recession, and finally the re-branding/launch of ISIS, and the US glut could potentially have been absorbed. But all this financial and geopolitical instability has instead rocked global demand just as the bulge in the fracked-shale production curve is peaking.

        Fracked oil is a short-term, excessively expensive non-solution. It is one giant weekend in Las Vegas that will leave the US in far worse shape nursing the hangover.

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