Crude Oil: The War For Market Shares

The bastion of the gulf region and OPEC is no more! Rise of unconventional oil industry in North America has brought tectonic shifts in the economics of global crude oil. But large exporters like Saudi Arabia and Russia are determined to defend market shares. The Oil Wars will only intensify.

Exhibit 1: Key players & price dynamics info-graphic:

Another elephant in the room

The century old infamous diamond cartel operated by De Beers was finally brought to its knees in early 2000 when large producers like Lev Leviev decided to build and control their own sources of supply. Many parallels can be drawn from that event and what is currently underway with crude oil and its producers.

Fracking, an unconventional drilling method, comes close to being a disruptive technology that has transformed oil production. Despite its existence for several years, it was only in the 1990’s that it found wider acceptance. Higher oil prices and newer technology drove the boom in fracking based shale oil production making U.S. the largest oil producer in the world. The largely unopposed OPEC cartel not only lost a major customer but also gained a rival. Price of crude (Brent) crashed by 61% to $45 from a high of $116 in June 2014.

Members of the oligopolistic cartel OPEC and large producers outside it like Russia, are feeling the heat. Saudi Arabia, the world’s 2nd largest oil producer and de facto power wielder in OPEC is coming to grips with the the fact that it cannot continue to influence and control global crude oil prices. The era of low energy prices is here. The supply glut caused by shale will act as a deterrent to erratic price fluctuations caused by the OPEC. In addition, demand from developed economies hasn’t recovered to absorb this supply and Emerging Markets are still not equipped to take on that role. So defending market share is the focus of the altered power struggle.

Lessons from history

There is a precedent to the current situation, the supply glut in the 1980’s. In it’s wake it brought about events that forever transformed the economic and geopolitical realities of the players involved. . .and many more.

OPEC, and through it Saudi Arabia, used to dictate global oil prices. The reason for its decision in November 2014 to maintain production levels lies with the kingdom’s experience of the supply glut of 1980’s. Saudi Arabia had cut down its production by almost 75% (almost 10 million barrels per day) in a bid to prop up the falling prices. It managed to achieve that. However it paid a price, by losing precious market share, when non-OPEC countries increased production to meet demand and some of its own members in its cartel did not adhere to the pre-determined production quotas. A loss in market share is predictably worse than taking a hit on margins. After all prices go through their cycles of booms and busts.

Russia too, will be well reminded of its bitter experience of the 80’s and the early 90’s. The drop in global oil prices of the 80’s was one of the catalysts for the economic woes and the eventual demise of the erstwhile USSR.

The notable outcome of the depression of the 70’s and the cartelisation of global oil price by OPEC was the shift in the US energy policy. The U.S. wanted to reduce its dependency on imports and build a counter to oil shocks in the future. Thus, they created their strategic oil reserve.

What’s at stake?

Producers like Saudi Arabia, Venezuela and Russia are heavily dependent on their oil exports to finance their economy. Oil share of government revenue for Saudi Arabia is nearly 90%. O&G are 68% of exports for Russia (33% crude oil exports, 21% petroleum products and the rest gas) thereby making up 50% of total government revenue. These oil dependent economies have been affected due to lower oil prices but the worst may be yet to come if prices continue to slide.

The U.S. shale industry does not face the same exigency but it incurs high costs of production and most companies are deep in the red due to substantial investments. And like any capital intensive industry, most of it is funded via debt at the moment. They need prices above a certain level to be profitable not only to service their debt but also to make a case for further investments.

Low prices will hurt producers across the board. But in the short term, they will hurt the U.S. shale producers more. Maintaining market share to offset some of the pain from loss in margins, is therefore critical in the global crude oil market that has moved towards competitive conditions from oligopolistic ones.

Manoeuvers and counter manoeuvres

Both conventional and the unconventional oil producers will try to fight this turf war from a position of advantage. It’s important to understand their ‘relative’ positions of strengths and weaknesses. We try to draw some perspective here while also outlining some challenges and opportunities that could tip the scales.

Exhibit 2: Relative strength & weaknesses of major participants

Saudi Arabia

One useful factor in favour of conventional producers is the high cost of shale extraction. Consensus estimates peg the ‘all-in’ figure at $65 as an average across shale oil rigs from different regions. Compare that with the rumoured cost of production that Saudi Arabia has of $5-$20. Although for balancing its budget its break-even needs to between $95-$100. If Saudi Arabia maintains its production levels, not only does it preserve market share but may also precipitate a credit crisis for the highly leveraged shale oil producers. In fact game theory suggests that Saudi Arabia stands to gain in multiple ways by ‘helping’ keep prices low.

While it may not damage the prospects of shale oil drilling forever, low prices of oil is likely to delay proliferation of this unconventional technique. These low prices will surely have an impact on Saudi Arabia’s budget but in the longer run it’s almost critical for it to ensure prices stay low. The rig count of shale oil producers may be falling off a cliff but recovery in prices will give them a new lease of life. Saudi Arabia cannot afford to give them that opportunity to consolidate and restart.

The famous ancient military treatise “Art of War” suggests, a prolonged conflict is a drain on resources and detrimental to success. Saudi Arabia may have just taken a leaf out of that chapter in their attempt to force economic losses to the shale oil producers. The cash rich kingdom has forex reserves of $697 Billion and will not hesitate to use it to cover its losses or to finance its annual budget while it wages this price war. Meanwhile it can utilize this opportunity to rationalise its rather lavish social spending plans in anticipation of the economic challenges looming ahead.

U.S.

On the other side of the pond, it’s evident that shale oil producers in the U.S. are very concerned about their prospects. While such a scenario was expected, the reality of the situation is harsh indeed. Rig counts have been steadily decreasing and is currently down 42% from their high in October 2014. Oil production hasn’t decreased as much as expected because the larger producers increased production to grab market share. Unexpectedly in the process, they have also challenged Saudi Arabia’s role as the swing producer. It wouldn’t be surprising if the U.S. shale producers take on this role in the near future.

In this regard, one of the critical tactics that can help the shale oil producers is their ability to rapidly ramp up and ramp down drilling operations. Mobility of labour will pose major challenges in times when ramping downs operations. However technological advances have enabled this industry to be more nimble than the traditional oil producers. Costs of production can be further reduced if the larger players consolidate or become sizable through smaller acquisitions. If production of shale oil continues to ramp up, the role of swing producer will be donned by the shale oil producers.

Lobbying to loosen the four-decade U.S. ban on exports of crude oil has intensified in the recent past. U.S. production has increased by 55% from 5 years ago to more than 8 million barrels a day. It still imports a lot of oil, but the amount of petroleum consumed from foreign sources, is currently at 33%, its lowest level since 1985. Currently, being the number one crude oil producer, it can afford to move towards exporting its oil. This would, in some ways, counter the challenges that they are facing.

Russia

Russia did not back OPEC’s suggestion to cut production to support prices. It maintained its output of 10.58 million barrels of crude a day. Lower prices cost the country’s economy as much as $100 billion in 2014 and was a severe blow to its currency. However, the depreciation of the ruble makes it relatively cheaper to produce oil in Russia (helping to preserve oil-company margins) and less expensive to other countries. Despite sanctions, Russia will not be willing to reduce production and will use this opportunity to gain market share through cheaper oil. On the other hand Russia is already looking at expanding its markets. The $400 billion gas deal in May is an indication of its strengthening economic alliances with an energy-hungry China.

Iran

A final nuclear deal in June will be a much awaited moment for Iran. Banking and oil sanctions will be lifted and crude in storage will start trickling into the markets. Iran’s oil and condensate exports had dropped from 2.5 million barrels a day in 2011 to 1.1 million barrels a day in 2013 because of sanctions. A complete lift of the sanctions can increase this to 1.4 million barrels a day. Iranian oil will sell at a discounted rate, firstly to recapture its market share and secondly, it is supplying to an already over supplied market.

What we can expect in the next round

Global demand is unlikely to be robust for the rest of the year. In the unlikely event that there are serious conflicts or wars that can hamper oil wells, routes or production, oil prices will not return to the high prices of above $100 a barrel. Fracking is currently prevalent only in the U.S., Canada, China and Argentina. However, with efficiencies achieved in production, it is an only a matter of time before other countries adopt it.

Saudi Arabia and Russia have already won the first round by holding on to production levels that drove prices down to $45. As this war for market share escalates the supply glut will most likely increase.