Thanks to the decision one year ago by Saudi Arabia to cast off its traditional role as the swing producer in the global oil market we have oil prices in and around 10 years lows. The strategy of Saudi Arabia has been to retain control of the global oil market by forcing marginal 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 and in addition Saudi market share has dropped and we even had the situation in May that Russia temporarily surpassed Saudi Arabia as the no.1 exporter to China, the world’s most biggest oil import market. There are a number of reasons why the Saudi strategy has not worked.
First and foremost US producers have been very slow to cut production and in fact quite the opposite, US oil production is up year on year. Many oil producers are continuing to generate profit thank to hedging strategies which mean that they have already sold this year’s production at higher prices. In addition, there is a deeply entrenched view in the U.S. amongst producers 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.
The second reason is that we have countries like Iraq coming back from a decade of internal strife and civil war. They are producing 0.5m barrels more than last year and have no intention of cutting production as they need the money. Then we have countries like Russia, Brazil and Canada which have seen their currencies weaken against the US$ which has lowered their costs of production relative to other producers. Unsurprisingly they have all increased oil production this year.
To add to this Saudi Arabia is under mounting pressure from other members of OPEC who are suffering from the low oil price. That said so is Saudi Arabia itself which, according to the IMF, is expected to run a fiscal deficit this year of 19.5% of GDP in 2015, compared to a deficit of 3% of GDP in 2014. Of course it is sitting on over $724bn in foreign currency reserves but the IFM is estimating those to fall by $60bn this year. How long can they hold out? Years if they want but this may impact their credit rating and the question is whether they will win in the end. Will they be able to regain control of the global oil market? The answer in short is no.
Going forward we are likely to see additional capacities coming online from low cost producers such as Iran and Iraq as well as Brazil and Russia. And then we have a weak Chinese economy which has been the main driver for oil demand over the last decade. This does not bode well for Saudi Arabia’s strategy. In addition, they have already lost their position as the No. 1 in global oil to the U.S. which produces more oil and oil liquids than Saudi Arabia. And Russia is very close behind.
That said, Saudi is not likely to be the near-term source of supply adjustment. That is most likely to come from the U.S. given the short-cycle nature of shale oil production and pressure from the capital markets. But the decentralised and short-cycle of shale oil production, as well as a deep and experienced oil capital market, means that any price increases will be met by increasing production in the U.S. This will make it a very hollow victory for Saudi Arabia. So what should Saudi do? It may well be that Saudi has to use its strong position within OPEC to cut production and accept being no. 3 in the global oil market. Will they do that? Probably not which mean that we are in for more volatility in the oil price in the coming months.