Are the Saudis Winning the War Against Shale?

Saudi officials insist the kingdom's oil production strategy is not aimed at putting U.S. shale producers out of business, a message that has been repeated to visiting U.S. policymakers.

The United States remains the kingdom's most important security partner, and Saudi officials do not want to be seen to be deliberately trying to halt the shale revolution.

Rising domestic oil production is important to U.S. policymakers because it has given the United States a greater sense of energy security, and the Saudis remain keen not to offend their most important ally.

Saudi officials talk about defending market share and refusing to subsidise "high cost" production which encompasses unconventional output such as oil sands and frontier areas such as deep water and the Arctic.

In response to the plunge in prices, capital expenditures totalling almost $400 billion on a range of exploration and development projects have been axed or postponed, which will reduce non-shale non-OPEC production in the latter part of the decade.

In the short term, however, the brunt of the oil market adjustment has fallen on shale producers, since other forms of exploration and production have much longer lead times.

The battle between Saudi Arabia and the shale producers has been a war of attrition in which progress has been slow so far.

But the most recent data show the tide may finally be turning in the kingdom's favour, as U.S. shale producers run out of cash and fresh financing, and are unable to maintain output.

TURNING THE TIDE
Even after oil prices began falling in June 2014, U.S. production (including condensates) continued to increase by another 1 million barrels per day (bpd).

Between June 2014 and its peak in April 2015, oil output rose from an estimated 8.7 million bpd to 9.7 million bpd, according to the U.S. Energy Information Administration.

Since April 2015, production has fallen, but it was still running at 9.3 million bpd in November 2015, the latest month for which reasonably comprehensive estimates are available.

How much progress this represents depends on the baseline against which it is measured. In absolute terms, output has fallen by around 375,000 bpd between the peak in April 2015 and November 2015.

If output had continued to increase on its pre-June 2014 trend, it would have been running at almost 11 million bpd by November 2015.

The reduction compared to the pre-June 2014 trend is around 1.6 million bpd, which is one measure of how far the strategy has worked (http://tmsnrt.rs/1RQ86rg).

The EIA was more cautious about the outlook for U.S. oil output; in June 2014 the agency predicted oil output would be running at 9.5 million bpd in November 2015.

The price war has reduced production by around 150,000 bpd compared with this more conservative baseline (http://tmsnrt.rs/1RQ9eeq).

So the impact of the price war on U.S. shale output could be estimated at anything between 150,000 bpd and 1.6 million bpd.

Shale proved far more resilient than almost anyone thought possible as producers concentrated drilling and expenditure on the most promising areas, accelerated drilling times and optimised fracturing operations.

The result is that the Saudis have been forced to push prices much lower for much longer than they anticipated to defend their market share and rebalance the market.

WINNING BUT AT A COST
The effort may finally be paying off as a result of the latest downward lurch in prices. The U.S. shale industry finally appears to have reached a tipping point where output is contracting rather than just flat-lining.

The EIA has revised its projection for end-2016 output down from 9.7 million bpd in July 2014 to just 8.5 million bpd in February 2015 ("Short-Term Energy Outlook", EIA, July 2014 and February 2015).

Low prices are expected to remove another 800,000 bpd from the market by the end of this year. Even that may prove to be too low because the EIA's forecast is conditioned on WTI recovering to $43 by end-2016.

Oil production in North Dakota, one of the states at the heart of the shale boom, fell to just 1.15 million bpd in December 2015, down almost 6 percent from the all-time high of 1.23 million bpd in December 2014 (http://tmsnrt.rs/1RQ8KoD).

"Oil price weakness is now anticipated to last into at least the third quarter of this year and is the main reason for the continued slowdown," according to the chief of the state's Department of Mineral Resources (http://tmsnrt.rs/1RQ8Oob).

In the meantime, however, the market remains severely oversupplied. Global inventories of crude and refined products have climbed by 1 billion barrels according to the International Energy Agency (IEA).

The precise scale of the stock build is disputed but there is no doubt inventories have climbed substantially as a result of the supply-demand imbalance.

In the United States alone, for which there is high-quality data, stocks of crude and products have risen by more than 300 million barrels over the last two years, or 220 million since prices started sliding.

The EIA currently projects global oil inventories will continue increasing by 1.0 million bpd in 2016 and 0.3 million bpd in 2017.

The market is not expected to rebalance until the second half of 2017, after 14 quarters of inventory builds, according to the EIA ("Crude oil prices expected to remain relatively low through 2016 and 2017", EIA, January 2016).

For its part, the Paris-based IEA predicts global stocks will increase by 2.0 million bpd in the first quarter of 2016, 1.5 million bpd in the second, and 0.3 million bpd on average in the third and fourth ("Oil Market Report", IEA, February 2016).

"If these numbers prove to be accurate, and with the market already awash in oil, it is very hard to see how oil prices can rise significantly in the short term. In these conditions the short term risk to the downside has increased," the agency warned earlier this month.

LONG-TERM ATTRITION
As one of the lowest cost producers, with ample financial reserves, Saudi Arabia can eventually win any price war provided it pushes prices low enough for long enough.

There are serious questions about whether Saudi Arabia's strategy of flooding the market in the short term in order to strengthen its long-term position is worth the cost.

The improved techniques which enabled the shale revolution cannot be unlearned. If and when prices eventually rise, shale production will eventually increase again.

The cancellation of conventional, unconventional and frontier projects will be harder and slower to reverse but they too will eventually come back if oil prices recover.

The most durable gain Saudi Arabia can hope to achieve is if the price war scatters and dismantles much of the skilled workforce and ecosystem of specialist oilfield service and supply companies.

That would create a much bigger and longer lasting disruption of competing oil supplies which in turn will give the kingdom more pricing power in the medium term.

In the meantime, the strategy is costing the kingdom more than $100 billion per year in terms of extra borrowing and lower foreign reserves.

Rating agency Standard and Poor's estimates the kingdom will run budget deficits averaging 9 percent of GDP between 2016 and 2019.

The government has budgeted for a deficit of about 13 percent in 2016, based on an oil price of around $45 per barrel, Standard and Poor's estimates.

The kingdom is also forecast to run a deficit on the current account of its international balance of payments equivalent to 14 percent of GDP in 2016.

On Feb. 17, Standard and Poor's cut the kingdom's foreign currency credit rating two notches from A+ to A-, with a stable outlook.

Protecting the kingdom's market share is proving expensive. The question in the end will be: was it worth it? Only the Saudis themselves will know the answer.

By John Kemp