US shale pressures Opec

Riyal

Opec is expected to commit to keep their reduced crude output quotas at a meeting in Vienna on Thursday in a bid to boost the oil price. But rising US shale production could derail Saudi plans.

The discovery of oil in commercial quantities in 1938 changed Saudi Arabia forever. It boosted the country’s wealth and influence, with its GDP soaring from unremarkable levels to the 20th highest in the world. But any investor knows you should not put all your eggs in one basket and the entire Saudi economy depends on petrodollars. The recent oil-price slump demonstrated the weakness in its economy. The oil price collapsed from more than $100 a barrel in 2014 to around $30 last year and it sits at about $51 today.

The Saudi Kingdom’s rulers used petrodollars to employ their citizens in the civil service with generous perks. This ensured the masses were happy with the rulers – but 85% of private sector employees were expatriates. It will be a significant challenge.

However, the oil price slump damaged the country’s finances significantly and has forced its rulers to make radical changes. This is necessary and, arguably, overdue. With the country’s demographics skewed towards youth, the country can’t afford to continue with such largesse. Indeed, credit rating agencies Fitch and Standard & Poor’s downgraded their view on the country in March this year for these reasons.

The Saudis have therefore announced a radical overhaul of their economy to boost the private sector. Economic reformers in the Kingdom have staked much on a successful flotation next year of state-owned oil giant Saudi Aramco, which they have predicted will achieve a valuation of at least $2 trillion. Officials plan to sell a 5% stake. The Saudis need a relatively high oil price in order to get a good valuation and swell depleted government coffers. This is why lower quotas are expected to be agreed by Opec this week, even if the Saudis end up taking the bulk of the cuts on the chin. Indeed, the country is already producing even less oil than it said it would. Its cuts in April equated to 118% of its quota.

Getting a good valuation for Aramco appears to now be more important than maintaining market share. Saudi Arabia could have taken on its traditional role as the world’s swing producer and reduced production in the early part of the slump. It didn’t because it did not want to lose market share to the US unconventional oil producers, with the added benefit that low prices made much of US shale production uneconomic.

US shale producers have stepped on the accelerator, with many US groups guiding to double-digit production growth this year. This means that Opec cuts may not matter that much, should they just be replaced by rising output in America.  Macquarie Group thinks shale production will increase by 1.4 million barrels a day for the rest of the year, up from a previous estimate of 0.9 million barrels a day. JPMorgan has also doubled its forecast and now sees an increase of 800,000 barrels a day by December.

If Opec’s production cuts are extended on Thursday, it is likely to lead to a loss of market share. The Saudis will be keen on fighting for higher prices, but other member states may not be willing to continue to lose market share for a protracted period of time.

Because of these dynamics, we see the oil price trading in the $50 area for some time. The Opec cuts will provide a floor to the price with US shale production a ceiling, ensuring that the price is range bound. These dynamics are likely to persist until the global glut of oil eases or Opec members blink.

 


The above article was first published by Charles Stanley on 22nd May 2017.