Saudi Arabia "Takes the Gloves Off": moment of truth arrives for US shale.

Mark Lewis for Kepler Cheuvreux (no url): “Despite the dramatic recent fall in oil prices, OPEC decided yesterday to maintain its current production quota of 30mbd, thereby compounding market fears of a short-term supply glut and prompting a further sharp drop in the Brent and WTI benchmarks (both down 6.3% on the day to $72.8/bbl and $69/bbl respectively).”
Our long-term view on prices remains unchanged (we think supply constraints will ultimately force prices onto a higher and rising long-term price trajectory from 2017 onwards), but we now expect prices to be much weaker in the short-term than we were previously assuming. If the Saudis really are looking to take out a material chunk of the US shale industry – and after yesterday’s decision we think they are – then we think Brent prices of $60/bbl are possible in the short term (within the next 3-6 months). Such prices would likely put severe pressure on many shale operators, especially those whose production over the next 18-24 months is not fully hedged, and will also greatly increase the pressure on the oil majors to make meaningful cuts to their future capex when they announce their full-year 2014 results in Q1 of next year. This only serves to underline our view that the oil majors now need to radically overhaul their business model and become energy majors.
Oil prices have been crashing since June, and fell very sharply yesterday after OPEC’s decision not to cut: Figure 1 shows the decline in the Brent crude-oil price over the last week, highlighting yesterday’s very sharp fall. Brent fell by 6.3% yesterday, and is down again this morning trading currently at $71.8/bbl. This means it is now down by nearly 40% since its high this year of $115.7/bbl reached on 19 June. So what is going on?
Saudis want to re-assert authority over the oil market: In our view OPEC’s decision should not have come as any surprise to the market. This is because it has become increasingly clear over the last two months that Saudi Arabia sees current price weakness as an opportunity to re-assert its authority over the oil market, an authority that has been increasingly questioned in the last three years with the surge in US shale-oil production. Indeed, we think  OPEC’s decision to maintain current production levels reflects both (i) Saudi Arabia’s pre-eminence within OPEC (it is inconceivable for OPEC to cut production without the Saudis’ taking the lead), and (ii) the Saudis’  determination to put the squeeze on the US shale-oil industry. With OPEC not now due to meet again until 5 June 2015, the market has six months to wait before the Organisation’s next scheduled review of the supply-demand balance. It is true that yesterday’s press release made reference to the group’s “readiness to respond to developments which could have an adverse impact on the maintenance of an orderly and balanced oil market” (and hence to the possibility of an extraordinary meeting before 5 June should prices continue to fall too far too quickly), but we think the plain fact now is that unless or until the Saudis decide to cut production, prices will remain under pressure.
Why do the Saudis hold the key to OPEC action?:  The Saudis hold the key to OPEC action because only they can afford to make the kind of supply cut that would actually make a difference to the market balance. As yesterday’s OPEC press release said, “although world oil demand is forecast to increase during the year 2015, this will, yet again, be offset by the projected increase of 1.36mbd in non-OPEC supply”.  It then went on to say: “The increase in oil and product stock levels in OECD countries, where days of forward cover are comfortably above the five-year average, coupled with the ongoing rise in non-OECD inventories, are indications of an extremely well-supplied market.” Against this backdrop – and with Libyan production possibly headed higher in the near term – we estimate that other OPEC countries would have to cut production by at least 1mbd, in order to make a meaningful difference to the market balance (and hence to prices), and that Saudi Arabia would have to bear the brunt of this. But far from looking to cut supply, the Saudis have in fact recently been cutting prices, not least for US customers. We do not think that Saudi Arabia wanted prices to fall below $100/bbl in the first place, as they had until recently been consistent since February 2012 in saying that $100/bbl was a fair price for both producers and consumers. However, once prices had gone through $100/bbl decisively by late September, we think the Saudis – as the lowest-cost producer in the world, and with the third-largest level of foreign-exchange reserves globally after China and Japan – saw an opportunity to re-assert their authority over both geo-political rivals (Iran and Russia), and commercial rivals (US shale operators).
No other price support in sight in the short term:  With OPEC production set to remain at 30mbd for the next six months, there is now no other meaningful source of price support in the short term in our view. Of course, all other things being equal lower prices in and of themselves should give a boost to demand. However, even though Brent is now almost 40% off its 2014 high of $115.7/bbl set on 19 June, we think it will take time for demand increases to feed through. Against that, and paradoxically, the risk is that, in the absence of an OPEC supply cut, producers might actually try and pump more volume in the short term to compensate for the lower market value, especially US shale operators.
Conclusion: long-term view unchanged, short term view now more negative:  As we re-iterated in our Alert of 13 November (No Recoil from the Toil for Oil), we remain of the view that over the long term supply constraints will force prices onto a rising trajectory, with prices back at $100/bbl  by 2017 and rising in real terms thereafter. What we also said in that Alert, however, was that “the Saudis’ apparent willingness to accept lower prices for a period could put even more pressure on crude prices in the near term”, and we are now convinced that this is indeed the Saudi plan. As explained above, Saudi Arabia has the oil market under its control again, and we expect it to use its re-discovered authority in a way that puts maximum pressure on both their geo-strategic and commercial rivals.
Against this backdrop, we think that Brent prices could fall to $60/bbl in the short term (i.e. within the next 3-6 months), and that this will bring severe pain both to US shale oil operators, and the international majors. In turn, we think this will lead to a renewed build-up of pressure amongst certain other OPEC members for an OPEC supply cut to be announced at the Organisation’s next scheduled meeting on 5 June. At the moment, however, the 5th of June 2015 is a long way away, and we see no other obvious source of price support in the interim unless and until the Saudis decide it is time to cut production.”