Sunday, October 18, 2015

The Saudi Plan To Bankrupt American Oil

15 months ago, if you'll recall, oil was $102/bbl.  A moment ago, a check showed it at $47.35.  In between these lies a story and some lessons.

The first thing to note is that when oil had been around $100 for a while, everyone thought the days of sub-80 or $90 oil were long gone and they'd never be seen again.  Today, you'll read pundits saying that oil will stay below $60 and we'll never see $100 oil again.  That epic shortsightedness is lesson #1. 

Last December, I ruminated a bit on the price of oil and what may be going on.  This weekend, I see a summary by Jim Rickards that makes it appear I was right all along.  I wrote:
I think there can be a bigger game going on here, though.  The principal power in OPEC is the Saudis.  The Saudis have no use for the Iranians and are frankly terrified of a nuclear Iran.  You can bet your butt that if Iran goes nuclear, the Saudis will go nuclear as well.  For a country that nominally hates Israel, they've quietly agreed to allow Israel to over fly Saudi territory if needed to attack Iran ("the enemy of my enemy is my friend" in action?).  They also want Assad out of Syria and Russia is propping up both Iran and Syria.  I think it's entirely possible that Saudi Arabia could be playing the game to get Putin out of the area, and try to collapse the governments of both Iran and Syria.  Russia's economy is already showing signs of trouble.  If they collapse Putin himself, get him ousted by ballot, by revolt or worse, I think the Kingdom would view that as a good thing.  I also can't imagine the Saudis would be too upset if they found a price for oil that shut down American shale oil production. 

I included this handy graph of the price to balance the national budgets of several oil producers.
A vitally important piece of information which was missing from this chart was the cost per barrel of fracked oil.  What does it cost to produce a barrel in the American and Canadian oil fields?  The fracking industry assumed oil would remain in a range of $70 to $130 per barrel and based their business model on this. Over $5 trillion was spent on exploration and development, much of it in fields like the Bakken formation and the Colorado/Wyoming Niobrara oil shale.  

As I said last December, OPEC, and particularly Saudi Arabia, found themselves in a tight situation: not making enough profit from their sales to be fully comfortable.  Note I said enough profit.  Saudi Arabia is unique in actually being able to produce oil at a profit for as little as $10/bbl!  One thing was abundantly clear, though, unless they did something to strike back at the American production, they were condemned to low oil prices for the foreseeable future.  As Rickards says, the Saudis could survive with oil at $30, but it would be hell on their budget.  $80 would be good for their budget, but would probably allow the American frackers enough breathing room to stay alive.  Instead, they went for a price comfortably below that $70/bbl price they believed was the price of American oil. 
It turned out that the optimal solution for the Saudi problem was $60 per barrel. A price in the range of $50 to $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
Oil at $60 has the added bonus of hurting both Russia and Iran, as well America.  It's win-win-win for the Saudis.  If you look at the records of the past year, the price of oil hit the Saudi target price of $60 per barrel by the end of 2014. But it kept going down. The price hit $45 per barrel in January 2015 and $40 per barrel by this past summer. That was due to normal market overshooting and momentum trading. It was also due to the fact that desperate frackers actually increased production to meet the interest payments on their debt even thought they were in the process of going broke.

Assuming war doesn't break out in the Persian Gulf region, I can see oil staying in the ~$45 to $60 range for a while; specifically, until the American fields are largely shut down and the workers moved back out of North Dakota and other places.  It will stay there until it will take a couple of years for the US industry to get fully mobilized again.  For planning purposes, figure some time in 2017.  

If you have enough Ferengi in you to be wondering how you can make some money out of this, should this all be true and not just fever dreams from your humble blogger (and, strangely, Jim Rickards), consider the following scenario.  In gold and silver mining, companies are broadly sorted by size into what are called juniors and majors.  Juniors are the startups; the hotshot geologist and a small group who go prospecting and find the new deposits to mine.  The majors leave this work to them because it's highly risky.  A lot of juniors go broke working on a deposit that doesn't end up being worthwhile.  On the other hand, once the juniors find a good deposit and start extracting the gold, the majors buy them out.  There's a similar stratification in the oil world, too, with smaller companies and the vast multinational majors. 

In this case, the juniors are likely to get squeezed out.  The small budget American frackers are going to be in trouble.  The big Majors, though, have the resources and intercontinental connections to survive it.  Those companies will go on a buying spree, picking up sources for pennies on the dollar starting soon (if they haven't already) and stretching through '16.  If this happens in 2017 as outlined, they'll start making money at a prodigious rate. 

Standard disclaimer: I'm not an expert in this stuff at all.  I'm just some random dood on the Intertubes with a blog.  I just observe things and think about them.  If you're taking advise from random people on the Web, you deserve what you get.
Brent Crude - one of several benchmark prices for crude oil.  Looks like it's staying in a trading range to me! 


  1. Yes....the House of Saud is trying to shut down competition. And
    eventually they will succeed. In the short term. But oil and it's price is especially cyclical. It has rarely been kept at a steady reliable price as it is a commodity that allows for people to get rich quick if they are lucky and early. So eventually the US
    will produce less oil.....till once again the demand causes prices to rise to a point where production becomes profitable. And the cycle starts over. The KEY is for people to make buttloads of money while they can then SAVE IT for the inevitable downward swings so they can survive till the next turn of the cycle. But humans are clever, not intelligent. Thus most spend big when they earn big and go bust when they don't. But as long as their is oil in the ground someone somewhere will find a way to get at it and make money at it.

  2. I recall experts in the early 80's proclaiming we'd never see sub 10% interest rates evah again, guaranteed!

    Interesting that what the precious metals market experienced - rapid price increase, frantic exploration, boom in production (fueled by investment/borrowing) then a crash, has now happened to oil. Imagine. Who would have known?

    The house of Saud seems itself to be in somewhat of a bad place - verging on civil unrest, and lotsa princes/princelings to keep happy. A palace full of concubines must be expensive to support. No longer the days of Scheherazade.

    Yet, they have the Halfrican bringing up the rear, uh, providing material support I mean. With his/her/its bow to your Sensei demeanor, success is assured!

    This is a long con - they, and their 'murkin central banker/petro friends have been at it for decades - generations really, and got the whole scheme nailed. That is, as long as the other oil producers stay in line. And accept dollahs for payment. And control that Sunni/Shia split - you know - Iran/Syria (along w/ Russia, as ally) vs house of Saud & the halfrican. Oh yeah - don' wan no steenkin' pipeline, unless a US contractor controls it - terrists you know.

    Got no idea what the differential is betwixt oil produced vs user cost at the pump of fuel, US/middle east, except that proportional comes to mind. A pipeline Should Be Much Cheaper than tankers, but then there's the halfrican angle, again.

    So, US investors, and banks (backstopped by US taxpayers) do the heavy lifting of exploration & developement of Bakken, price of oil collapses, heh - who's gonna be around to pick up the pieces?

    Pump 'n dump. Then pump again.


  3. I disagree. The Saudis didn't lower the price instead they simply choose to not reduce output which would have kept prices high. Why didn't they? Because they too need the money. The low oil prices are hurting Russia and Venezuela the most.

    As for the cost of fracked oil. More complicated than that. The cost to drill the wells requires a certain oil price for them to break even. BUT once the well is drilled and producing it does so at almost no cost. So they can't just shut it off. They make more money selling it at the lower price than not selling it. The sunk costs are paid for and gone no matter what the current price is so all they will do is stop future drilling until the price returns.

  4. LIke the first comment says.

    Don't matter.

    We learned a lot while prices were high.

    When the prices come back up, and they will, everything shut down will fire right back up.

    The thing that has to terrify The House of Saud is us figuring out that we can go it without them. We don't need them at all if we accept the higher price of domestic production.

    To be rid of Islam? All I need to do is pay $3.509 at the pump? WORTH IT!

    Let them eat their oil with a side of sand.

    By the way, if we'd just get the damned government and it's endless regulatory boot off the neck of the entrepreneurs adding to domestic production, it'd be even cheaper than it historically has been.

  5. I'm not quite ready to sell the 'Murricans short. One thing we do better than anyone else is overcome adversity; there's certainly a minimum value for fracking below which it absolutely is not affordable to continue operations, but I'm not convinced we're there yet. Undoubtedly the pursuit of less expensive fracking operations will leave blood on the floor, and it may be a lot of blood, but there's also untouched oil that doesn't need fracking to extract.

    Russia is, and has been, desperate for income and oil sales are a big source of those monies; there's little doubt that it's possible to hurt Russia with continued low oil sales values. Would that we had a government in the U.S. that understood America's place in the world and recognized its obligation to use our strengths to maintain it.

  6. A couple comments to provide more information on the subject:
    - I agree with Alien; don't count Americans out: Continental's CEO (the one going through the messy public divorce) talked 2 months ago about how his company had cut well costs by 30% and could probably manage another 30% in the next year; in the past there was an incredible amount of waste in horizontal drilling and fracking; there is now incentive to find and eliminate that waste.
    - Cost to break even varies wildly depending on company, the field being used, local regulations and infrastructure, etc, etc - any industry wide guess isn't worth the pixels they use on the screen.
    - Yes, Saudi Arabia hasn't reduced production as is widely commented, however they haven't increased it all that much either. One of the BIG reasons for the supply glut and hence low prices is that right now all of the approximately 100 'major' fields in the world (with the exception of Iran) are producing and exporting. This is an EXTREMELY RARE event. At any given time in the last 30 years, 2 to 4 of those fields had their output limited due to equipment problems, weather, pipeline issues, local unrest, currency issues, etc. To me, the impetus for the recent drop was Iraq and Libya being brought fully online while nobody else went offline. I am surprised this stability has lasted as long as it has given the historic instability of many of these fields. It is not a question of whether prices will go back up; it is a question of when they will go back up!
    P.S. in January 2015, gas prices hit a low here of $1.69/gallon - it is currently hard to find it under $2.25/gallon; I expect prices at the pump to continue creeping up no matter what spot prices do.

  7. There is a huge irony here. The lower prices are good, NO Awesome for the American economy. But not awesome for certain industries and investors. So the push is on to increase prices but not so much the price of crude but the price at the pump. We will see prices of gas go up and we will see a push to export American oil as a way to prop up the American investors and companies who aren't too happy with the low prices and low demand. the result will be the opposite of "awesome for the American economy" but so what as long as a few powerful investors with the congress in their pocket do well. So what's different now yu ask? A lot. In the last 50 years America has had zero say in the price of crude or the price of gas at the pump. That is the Saudi's and other nations have controlled crude prices when they can but not the U.S. Given that the lower prices are probably the single reason the American economy hasn't collapsed today why would America, when they finally get a chance to have some control over oil/gas prices, why would they increase them even though the low prices are good for the economy? For that matter, why would they increase those prices at all? Why not let the price of crude be set in the international market AND let the price of gas reflect the crude prices plus costs and profit to make the gas. That is more or less the system in place for the last 50 years so why the change now? The fix is in. Somebody is going to become billions richer than they are now.