- The Washington Times - Wednesday, October 22, 2014

Consumers are enjoying a break from high gas prices, which have fallen below $3 a gallon in many areas, but the drop has precipitated a cold war among oil producers that has all the intrigue, suspense and looming destruction of a Tom Clancy novel.

Premium crude prices since June have plunged by 25 percent, landing Wednesday at levels near $80 a barrel in New York. That makes it painful or uneconomic for producers in Russia, Venezuela and Iran, for the pioneering shale oil drillers in America’s heartland and for Canada’s oil sands extractors.

The key player in the unfolding drama is Saudi Arabia. Despite uncomfortably low prices even for the wealthy kingdom, Saudis last week made it clear that they will not curb oil production in an effort to stabilize the market.

In fact, the world’s largest oil producer upped the stakes and increased tensions by announcing that it would cut prices to maintain market share in Asia, which is now the main destination for Middle Eastern oil.

The Saudis’ abandonment of their long-standing role as chief regulator of oil prices triggered a market plunge and sparked a rash of conspiracy theories. Some said the kingdom was scheming with the U.S. and its army of shale drillers to flood the market with oil and bankrupt rogue players such as Russia, Venezuela and Iran.

A steep drop in oil prices during the Reagan era led to the collapse of the Soviet Union, which, like Russia today, depended on oil as the lifeblood for its economy and government revenue.

The drop in oil prices complements sanctions imposed by the West over Russian aggression in Ukraine this year. Oil speculators suspect the move serves to drive Russia’s economy into recession.

Moscow no doubt is feeling serious pain. Analysts say it needs prices to stay above $105 a barrel to maintain the flow of oil revenue into government coffers.

“Eighty dollars per barrel does great economic harm to our enemies Russia and Iran,” said economist and CNBC commentator Lawrence Kudlow. “That’s a good thing.”

U.S. adversaries Venezuela and Iran, like Russia, depend on oil to power their economies and need prices as high as $125 a barrel to stay fiscally solvent. They could face an all-out economic collapse if the price drop is sustained.

The radical states have been among the most vocal members of OPEC to express alarm. Venezuela is calling for an emergency meeting of the cartel to forge a pact to curb production and prop up prices. The next regularly scheduled OPEC meeting is Nov. 27.

Shale drillers hit hard

The price pain also is felt at home, and some analysts say American entrepreneurs in the shale oil patch could be among the biggest losers.

By various estimates, the shale drillers and companies tapping into Canada’s oil sands need prices to stay above $50 to $80 per barrel to stay in business.

Some scenarios show that a sustained drop in oil prices for months or years could cause the bankruptcy of many shale producers and force companies to shut down drilling operations and lay off workers, slamming the most robust part of the U.S. economy in the process.

Another school of analysts with a taste for drama says the Saudis are trying to force North American producers out of the oil market.

Putting pressure on the shale drilling industry would eliminate the most immediate cause of the growing glut of oil on world markets, which has become a problem for the Saudis and other longtime Middle Eastern producers. U.S. production unexpectedly surged by 4 million barrels a day in the past five years thanks to the shale oil revolution — displacing Middle Eastern imports to the U.S.

“They’re looking to the U.S. to cut production before they do,” said Robert McNally, president of the Rapidan Group LLC and a former energy adviser to President George W. Bush. “That’s the new message that’s just now arriving to the oil patch in the United States.”

The Saudis appear to believe that U.S. shale producers have as much flexibility as they do to turn on and off their oil supplies, he told Platt’s Energy Week TV. But he said producers in Texas expect Saudi Arabia and OPEC to act before they do, putting the two sides on a collision course.

U.S. drillers “are sort of bullish. They’re kind of confident that oil prices are going to remain strong,” he said. “And when you started to broach the subject, well, what if they continued weakening? I sensed a confidence that, again, Saudi Arabia and OPEC countries would have to cut [output] to keep prices at $90, where most of these folks would be economical in terms of the shale oil production.”

With neither side willing to move first, oil prices could continue to plunge, Mr. McNally said.

“I think Saudi Arabia could withstand a drop into the $70s or $60s for a short period of time — much better than some of their rivals like Iran, which needs $130 oil,” he said. “And also Saudi Arabia has a war chest, about $750 billion it’s earned in recent years, and they can draw on that if necessary to tide things over while they sweat some production out of the U.S. and other competitors.”

U.S. producers may tolerate lower prices longer than many expect, he said, in part because investors in the shale companies are looking for increased production rather than profits. Nevertheless, Mr. McNally expects that a revival in U.S. production would level off quickly and start dropping if prices stay between $50 and $80 for an extended time.

“The prices will continue to fall until one side or the other or somebody is willing to indicate they’re able to withdraw supply,” he said.

Though the Saudis need oil prices above $82 to finance their lavish social spending and economic plans, they and other Middle Eastern producers such as Kuwait and the United Arab Emirates can easily survive a drop in prices because their costs to produce oil are far lower than those for North American drillers or Russia.

Extracting oil from shale and Canada’s oil sands costs $50 to $100 a barrel, compared with $25 a barrel on average for conventional supplies from the Middle East and North Africa, according to the International Energy Agency.

The drop in oil prices “has exposed a vulnerability” for U.S. producers, said Peter N. Rigby, an analyst at Standard & Poor’s Corp. “Innovations in horizontal drilling and hydraulic fracturing have not come cheaply. If Saudi Arabia starts a price war to maintain its market share, U.S. oil production could fall.”

OPEC is Saudis’ target

Some more sober analysts say the Saudis have a less-intriguing agenda: They are merely trying to put pressure on other OPEC states such as Iran and Venezuela, which in the past have taken advantage of the kingdom’s willingness to curb production when oil prices fall. These OPEC “cheaters” see Saudi restraint as an opportunity to keep producing to increase their own market share.

The kingdom’s change of behavior also reflects lessons learned during the 1980s and 1990s, when even drastic production cuts from 10 million barrels a day to 3 million barrels were not sufficient to raise prices. Saudis this time will seek a wider agreement within OPEC, these analysts say.

According to OPEC estimates, global production must fall by more than 2 million barrels a day in the first half of 2015 to balance the market. This is too much for Saudi Arabia to carry out on its own, said Bloomberg oil strategist Julian Lee.

Yet six OPEC producers — including Iraq, Iran and Venezuela — plan to boost output next year. Thus, Saudi Arabia is likely to seek individual output quotas for OPEC nations before it agrees to any cutbacks of its own, Mr. Lee said. Persian Gulf countries such as Kuwait and the United Arab Emirates generally are expected to back Saudi Arabia’s plan.

“At the end of the day, Saudi Arabia calls the shots,” said Mr. McNally, but it may decide action is needed before the next OPEC meeting. “They may announce a target lowering on Nov. 27,” he said, or “they may verbally express concern. But in terms of really adjusting supply voluntarily, only really Saudi Arabia would do that.”

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