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Oil in 2016: Entering the End Game

We have now lived through one and a half years of falling oil prices and continual overproduction across the world. We have seen analyst after analyst reduce their oil price targets. We have seen massive drops in CAPEX across the industry. We have seen job losses but still we see no stability in the oil markets. My view is that we will see the bottom this year. We will also see a pick-up in oil prices but none of this will happen until Saudi Arabia achieves what it set out to achieve one 18 months ago which is regaining control of the world oil market.

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.

OPEC crude oil production has increased by 1 million barrels over the last 18 months which is the extent of the current oversupply in the market. And half of that increase has come from Saudi Arabia who is clearly intent on pushing prices down. Furthermore, Saudi could increase production even further noting that it has spare capacity and the possibility of increasing production together with its neighbour Kuwait by 0.5m barrels in the so called Saudi–Kuwaiti neutral zone. And they also know that Iran will be putting out another 0.5m barrels per year of extra oil on the market once sanctions are lifted later this year. That’s another 1m barrels which Saudi could use to push oil prices to even lower. But what is Saudi trying to achieve?

There have been lots of theories that the Saudi decision is politically motivated against Iran but the reality is that it is about economics and long term positioning on the global oil market. And the reason for this is that Saudi has lost its dominant position in the global oil market and this has happened over a very short period of time. In 2011, Saudi was the world’s largest producer of oil and liquids. Today it is No.3 behind Russia and the United States. But the rise of the later has been nothing short of revolutionary. In 2011, USm oil and oil liquids production was 7.8m barrels a day. Last year it was 60% higher at 12.5m barrels. This has all happened because of advances in drilling technology and access to cheap capital from the US capital markets. And we have also seen strong appetite from investors in the UK, Canada and Australia to finance high risk oil exploration and development projects. But the issue is the more projects are developed and thus more production capacity the greater the risk for Saudi of being left with stranded assets at some point in the future.

The strategy of Saudi Arabia is to force the higher costs producers to cut production and preferably close while at the same time pushing up the cost of capital for these producers. However, this strategy has, to date, not worked. There are a numbers of reasons for this, the most important of which is that many oil producers have had oil hedges in place which have enabled them to generate positive cash flows even though their production costs (and sometimes variable costs) are higher than 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 are continuing to finance these oil companies. But for how long…

A large amount of those oil hedges will fall away this year which should cause many of these companies to have cashflow problems which will turn lead to restructuring and maybe even bankruptcies across the industry. The low oil price has already pushed up the costs of all new projects for investors and E&P companies and the longer the oil price stays at current levels the more expensive capital for any exploration and development projects will become. This is not good for those trying to develop ultra-deepwater, Artic, shale oil outside of the US and heavy oil projects. But it is good for low cost producers like Saudi Arabia who are clearing away future competition.

Finally, it is also interesting that there is talk of Saudi Arabia IPOing the biggest oil company in the world, Saudi Aramco. Now this could be seen as a sign of weakness given the low oil price, but I think Saudi will use the shares of that listed company as a currency to make takeovers across the world starting with shale oil companies in the United States. What better way to take regain control of the world oil market than forcing bankruptcy of lots of competitors before going in and taking over these low valuation businesses….