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Will Saudi Arabia Cut Production For Iran? Why $70 Oil May Come Sooner Than You Think
Aug. 16, 2015 2:36 AM
Summary
• North American and Saudi production has peaked.
• Drilling costs in Saudi Arabia are increasing as cheap onshore supplies are exhausted, forcing the Arabian Kingdom to develop expensive offshore reserves.
• New Iranian oil has already been reflected in the spot price.
• Barring a surprise purposeful OPEC production increase of 2+ million bbl/day, oil prices should have at least stabilized.
• Higher prices are possible if OPEC cuts production for Iran.
Background
The past year has been a blood bath for oil prices. The descent started last September, when overproduction from the United States caused prices to dip to the 70 dollar per barrel range. The price later went down further as Saudi Arabia and OPEC decided to keep production unchanged in November 2014. Having halved in value from a year ago, prices have been in $40-60 range since January.
While most everyone agrees that oil prices should rise above current levels, the timing of this rise is uncertain. Some, such as Goldman Sachs, claim that oil will not rise above 50 dollars until 2020, while others, such as T. Boone Pickens, think that the next bull market may be right around the corner. While it is impossible to predict oil prices with a crystal ball, the overall projection can be estimated by taking a look at fundamental factors that caused the crash in the first place. There are two main factors behind the current crash: 1) production increases in U.S. and 2) OPEC's Decision to keep production unchanged.
U.S. Production
Earlier this year, I wrote an article regarding correlating historical rig counts as well as well production data to model production growth and estimate the date in which U.S. production would decrease and its effect on oil prices. Not much has changed since the writing of my previous article as things have mostly gone as planned: ex-rig counts have plunged and U.S. production has at least stopped increasing. Although the article/state data contradicts EIA data in that the article predicted production would peak in Dec.-April while EIA data predicted production increases until July, the overall consensus is the same: U.S. production has peaked. The production decline is not surprising, since oil prices crashed to ~$50/barrel large shale producers within the industry have stated that they will not increase production until the market is more balanced. Instead of increasing production, many of these companies such as EOG Resources (NYSE:EOG) have developed a backlog of such wells to releasing should oil prices stabilize around $65/barrel. The fact that the number of such uncompleted wells has increased from 285 to 320 in Q2 2015 (when oil prices were ~$60/barrel) is a good sign that shale companies such as EOG are serious when they say that they will not release the fraclog until oil reaches $65/barrel.
All in all, the poor Q2 exploration and production earnings combined with decreased rig count should lead to U.S. shale oil production cuts in H2 2015. This, combined with Saudi Arabian seasonal production cuts, should lead to stabilization of production in the U.S. and Saudi Arabia.
Will Saudi Arabia cut production?
While oil markets around the world were sent into a tailspin in November 2014 due to OPEC, this time may be different. U.S. shale is not part of OPEC but Iran is. It didn't make sense to cut production for a non-OPEC oil producer. However, it does make sense to cut production for another member of OPEC. Otherwise there is no point to continue having semi-annual meetings as the last few meetings have resulted in zero change. While significant hurdles remain, several factors will likely have large impact on the Saudi decision. These factors include but are not limited to: rising drilling costs in Saudi Arabia, energy independence/national security, and Iran's willingness to make political trades for economic relief.
Rising Drilling Costs in Saudi Arabia
It is well known that Saudi Arabia is one of the few places on earth where cheap oil still exists. Conventional onshore fields such as the Gharwar, Abqaiq, and Khurais are known to produce plenty of cheap oil costing below $10/barrel. However, what is not so well known is that Saudi Arabia has developed significant offshore oil production facilities. Offshore drilling is, by nature, more expensive than conventional onshore drilling, as this chart shows. Offshore shelf drilling, as done in Saudi Arabia, can break even if the cost is anywhere from $20 to $60 per barrel. Based on those cost estimates, it doesn't make sense for OPEC countries such as Saudi Arabia to flood the market with cheap oil as such an action would make their own offshore fields economically unviable.
Energy Independence - National Security
In additional to the higher costs involved with obtaining oil in this environment, it is also important to consider the fact that oil is also arguably the world's most important commodity. For national security purposes, every country wants some sort of energy security / independence. This means that countries with state owned oil companies will develop their own reserves even if oil goes to 10 dollars a barrel. This point is reinforced by the fact that, companies such as BP (NYSE:BP) and Petrobras (NYSEBR) recently announced new deepwater drilling projects in spite of low oil prices.
No matter how much market share OPEC hopes to obtain by lowering prices, other countries will still develop their own reserves. Despite the intense rhetoric surrounding OPEC, recent seasonal production cuts from Saudi Arabia is a sign that OPEC favors stability over market share.
Political Trades in Exchange for Production Cuts
While national security is an important reason for OPEC not to increase production, one also has to consider the international relations in one of the most volatile regions of the world before deciding on oil prices. I'm not a political scientist, so I won't even try to discuss religious or political issues between Iran and Saudi Arabia. However, the fact remains that Iran was able to leverage nuclear limitations in order to obtain sanctions relief from the U.S. Likewise, the country should also be able to leverage proxy wars with Saudi Arabia in order to obtain a production cut. This kind of leverage could involve the trade of political concessions such as reduced support for Assad in Syria or Houthi Rebels in Yemen in exchange for a production cut from Saudi Arabia.
Conclusion
Most of the bad news has already been factored into the oil prices: U.S. production maxed out, Saudi/Russian production maxed out, and Iranian oil guaranteed to come to market in December 2015. Going forward we have declining or stabilizing U.S. production, Saudi Arabia production cut to 10.3 million Barrels per day, increased motor fuels demand due to lower prices, and possible further OPEC production cut to make room for Iran. While seasonally weaker demand from refiners and China's currency devaluation could push oil into the 30's, China is still increasing crude imports and the overall picture looks good. Worst-case scenario, oil will most likely stay within the $40-60/barrel range until mid-2016. Best-case Scenario, OPEC cuts production for Iran and we see $65-70/barrel by the end of the year.
All in all, the U.S. shale producers have learned their lessons regarding rampant production growth and have recently greatly scaled back operations. Furthermore, rising drilling costs in Saudi Arabia, means that the Saudis should have no incentive to let oil fall much more below current levels. Finally, Iran's willingness to compromise with the U.S. for economic relief is a good sign that they may also be willing to compromise with Saudi Arabia for similar economic relief. Nothing in the oil market is guaranteed, but should Saudi Arabia cut production for Iran, don't be surprised to see $65-70 oil sometime between December 2015 and June 2016.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UCO over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.