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Impact of Shale Gas and Light Tight Oil Production in the US

Impact of Shale Gas and Light Tight Oil Production in the US

The uptick in US LTO, colloquially referred to as “shale oil”, has seen the United States grow oil production by some 4mbpd since 2008. The amount of oil from the US LTO surge is larger than the production of any single OPEC member except Saudi Arabia and has thus been a direct challenge to OPEC and more specifically to OPEC’s de facto leader, Saudi Arabia. Saudi policy is studied with a scrutiny comparable to that experienced by the US Federal Reserve Bank, European Central Bank and other central banks of comparable importance, simply because of its ability to manipulate the crude-oil market. Its response (or lack of response) to the US LTO surge is a debated topic, and the latest OPEC meeting in Vienna, on 27 November 2014, is arguably the first time a clear decision with respect to the LTO surge has been taken.

Figure 5 plots Saudi production movements (in pink) in response to the price of crude oil (in blue), demonstrating the Kingdom’s effort to target prices. In recent years, Saudi Arabia’s (and hence OPEC’s) target price has been known, as the long-serving Saudi Oil Minister Ali al-Naimi has occasionally communicated the price that Saudi Arabia considers “fair”. This has, however, been a moving target, as revisions are made each fiscal year to the Saudi budget, with commensurate adjustments to the price for crude oil that Saudi Arabia wants to receive.

Budgeting and internal stability: Riyadh’s social contract

Energy is the backbone of the Saudi economy, and the diligent use of its revenue has been crucial to maintaining stability within a kingdom ruled by an absolute monarchy. The high youth unemployment plaguing the region – which is considered to be one of the triggers of the Arab Spring – also affects Saudi Arabia. Despite maintaining a per capita GDP of $31,300 at purchasing power parity (PPP) and holding $739.5 billion (estimated 31 December 2013), the country feels the pressure to increase Saudi participation in the workforce and ensure a living wage (and to achieve these goals in a sustainable manner). Having such a disproportionate percentage (60%) of the population under the age of 30 means that the challenge of creating sufficient job opportunities remains a lingering problem and one set to grow in the coming years, as the population is highly skewed towards the young end of the population.

One effort to address this problem is known as “Saudization”, which entails substituting expatriate labour with Saudi labour. With an estimated 6 million expatriates employed in the Saudi economy, the scope for progress, quantitatively, is high. Indeed, efforts to increase the numbers of Saudi nationals in the workforce and reduce dependence on expatriates at Saudi Aramco have been successful; 87% of the workforce is now Saudi, but the oil and gas industry is capital-intensive, so it will never be able to support mass employment in the Kingdom. Instead, much of the opportunity for Saudization is in the services sector. In addition to Saudization, increasing the role of women in the workplace will do much to supplement household income. There has been a dramatic rise in recent years in the unemployment rate of women (Figure 7).

The Saudi Arabian government planned to spend $228 billion in 2014, up 4.3% from the year before. The recent 30% decline in world oil prices has led many to question the ability of key oil-exporting nations, including Saudi Arabia, to balance their budgets in the new price environment. This has inevitably led to questions about OPEC’s response. The question has chiefly concerned whether the cartel would cut production or leave output steady. The latter choice would almost certainly maintain or even decrease the current crude-oil price and, with it, state revenues.

Figure 8 charts the price of oil with break-even values for the budgets of key oil-exporting countries. Since October 2014 Saudi Arabia has been below the break-even value, and it is unknown how much longer the Kingdom would be willing to run a deficit – and, if it chooses to run a deficit, what benefits it expects.

Many analysts suspect that Saudi Arabia would be willing to run this deficit only in an effort to squeeze competitors out of the marketplace, hence increasing OPEC’s market power. The obvious target in this case is high-cost LTO production in the United States and, to a lesser extent, the Canadian oil sands.

Saudi policy response: market-share prerogative

Break-even prices in US LTO
Fig. 9 Break-even prices in US LTO. Click to enlarge.

OPEC ministers met on 27 November 2014 to decide which course of action to take with their production. The results of the meeting seem to point conclusively to the cartel confronting US LTO. The decision not to cut production means that OPEC collectively maintained output at 30mbpd from December 2014 to April 2015.

This decision is, however, not really a collective one. The OPEC meeting of 27 November 2014 followed the 24 November P5 +1 meeting regarding Iran’s nuclear programme, in which the possible lifting of sanctions against the OPEC producer was discussed. Iranian Oil Minister Bijan Namdar Zanganeh predicted that oil exports could double within two months, were the sanctions to be lifted (see Country Report: Iran). The outcome of the meeting was an extension to the sanctions regime until June 2015, when talks are set to resume. With the results in from the nuclear talks, Libya, Iran and Nigeria (one of two sub-Saharan African producers) have effectively continued to “cut involuntarily” since OPEC’s last coordinated reduction. Libyan output is 49% lower since the 2008 action, as militias battle for control of the country (see Country Report: Libya), while Iran’s is down 28% amid sanctions. Nigeria also lost 300kbpd of oil to theft and sabotage in 2013, according to the Nigerian National Petroleum Corporation. All of this means that the decision essentially came down to Saudi Arabia, who would provide the lion’s share of the ability to cut production.

Saudi Arabia made it known in advance that any action, if required, would require a commitment from all members, but this was not a realistic expectation. Indeed, according to the Petroleum Economist, information emerged after the meeting that Saudi Arabia would have been willing to cut production only if Mexico and Russia participated.

The stakes have been high, as the International Energy Agency (IEA) has warned that the price slide could continue into the first half of 2015. Indeed, in the wake of the meeting, the price slid below $70/bbl on 28 November 2014 (down from $115 in June 2014). It appears that the course is set for a direct confrontation with US LTO. IEA chief economist Fatih Birol said in late 2014 that the sharp decline in oil prices was good news for consumers but threatened investments in future supply, warning that US capital spending could drop by 10% in 2015 if oil prices were to remain at current levels. Later the same day, the US EIA trimmed its forecast of US crude production in 2015 by an average of 80,000bpd, saying drilling activity was likely to be lower because of an expected average price below $78/bbl for West Texas Intermediate (WTI) crude. As can be seen in the graphic below, most LTO reserves are not economically exploitable below $70.

Prince al-Waleed bin Talal, an influential businessman, called lower prices a “catastrophe” and expressed astonishment that the government was not attempting to push them back up. Yet Saudi Arabia’s long-term interest may, in fact, be served by a period of cheaper oil. Unlike most other exporters, it can afford one. Though public spending has risen in recent years, Saudi foreign reserves have risen as well. Net foreign assets were $737 billion in August 2014 – over three years’ current spending. It could finance decades of deficits by borrowing from its own reserves, even if oil were cheaper than it is now. The Saudis might conclude that the main beneficiaries of expensive oil have been non-members of OPEC. A period of cheaper oil could drive some high-cost operators out of business, discourage investment in others and let the Saudis regain market share. Since the OPEC meeting on 27 November 2014, the market capitalization of Apache and Marathon has fallen by 11%, of EOG Resources by 6.8% and of Continental (one of the largest players in the LTO space) by 20%. It remains to be seen whether Saudi Arabia can reduce the production capacity of these players in the medium term.