Will the Saudis Try to Drive Down Oil Prices?
Remember $100 per barrel oil?
Oil prices peaked at $115 in June 2014. It seems like forever ago. What kind of behavior did this high price produce?
Many oil producers assumed the $100 per barrel level was a permanently high plateau. This is a good example of the anchoring bias. Because oil was expensive, people assumed it would remain expensive.
The fracking industry assumed oil would remain in a range of $70-130 per barrel. Over $5 trillion was spent on exploration and development, much of it in Canada and the U.S.
This led to a flood of new oil, which reduced the market share of OPEC producers. Saudi Arabia was losing ground both to OPEC competitors and the frackers.
But then oil prices crashed.
They fell all the way to the mid-$20s in early 2016. Then another human bias began to creep into Wall Street analysis.
The same prominent voices that earlier said oil would stay high were now saying it would keep dropping!
Some well-known analysts were calling for $15 per barrel oil. These low-ball figures were just as much off base as the earlier expectations of $130 per barrel oil.
Today oil is trading over $70, up from $46 at the beginning of the year. Oil surged 3% overnight after President Trump announced he’s abandoning the nuclear deal with Iran. The re-imposed sanctions will limit Iran’s oil exports, which will limit global supplies (I’ll have more to say about Trump’s decision in the days to come).
How did oil prices go from the $20s a couple years ago to today’s $70? Let’s go back a few years…
In mid-2014, Saudi Arabia developed a plan to destroy the U.S. fracking industry and regain its lost market share. The exact details of the plan have never been acknowledged publicly but were revealed to me privately by a trusted source operating at the pinnacle of the global energy industry.
The Saudi plan involved a linear optimization program designed to calculate a price at which frackers would be destroyed. But the Saudi fiscal situation would not be impaired more than necessary to get the job done.
What makes Saudi Arabia unique among energy producers is that they actually can dictate the market price to some extent. Saudi Arabia has the world’s largest oil reserves and the world’s lowest average production costs. Saudi Arabia can make money on its oil production at prices as low as $10 per barrel.
This does not mean that the Saudis want a $10 per barrel price. It just means they have enormous flexibility when it comes to setting the price wherever they want. If the Saudis want a higher price, they pump less. If they want a lower price, they pump more. It’s that simple. No other producer can do this without depleting reserves or going broke.
A $30 per barrel price would surely destroy frackers but would also destroy the Saudi budget. An $80 per barrel price would be comfortable from a Saudi budget perspective but would give too much breathing room to the frackers.
What was the optimal price to accomplish both goals?
It turned out that the optimal solution for the Saudi problem was $60 per barrel. A price in the range of $50-60 per barrel would suit the Saudis just fine. That was a price range that would eliminate frackers over time but would not unduly strain Saudi finances.
Well, oil is trading at $70 right now, above the Saudi target.
A geopolitical shock in the Persian Gulf could send it back to $100. With Trump backing out of the Iranian nuclear deal, that possibility just became more likely. Rising dollar inflation could also take prices higher.
Does this mean the Saudis will begin pumping more oil to bring prices back down to the $60 range?
We’ll have to wait and see.
for The Daily Reckoning