Did Saudi Arabia get it wrong?

When crude oil prices fell by half over the second half of last year, it was partly because OPEC and especially Saudi Arabia decided to maintain production levels.   Somewhat similar to what is happening in iron ore, it was said that the Saudis were looking to drive marginal players out of the crude oil production game, the primary target being shale oil producers in West Texas, North Dakota and in Alberta, Canada.

But did the Saudis get it wrong?   Although the price of crude oil has recovered a little, and is now hovering around the $55-$60 mark, crude oil production in the USA is still growing.  U.S. crude oil production has grown since July 2014 by 0.8 MM barrels per day b/d), according to the Energy Information Administration and quoted by a report on the RBN website. “Clearly U.S. production growth will slow, but it is quite likely that 2015 will end the year about 1.1 MMb/d over 2014,” the report went on to say.

The US isn’t the only country growing production. According to the report, Russia, Saudi Arabia and other countries are still fighting for market share and are therefore pumping out increased quantities of crude.   Meantime, demand is not growing by as much, leaving the world long on crude oil supply, and likely getting longer.

Why are producers in the Eagle Ford, Bakken, Alberta and other tight oil and shale oil plays continuing to increase output, despite the much lower price? According to the report on the RBN site, producers are able to make money because most shale oil wells are multi-product producers. They produce natural gas and and natural gas liquids (NGL) at the same time as they produce crude oil.   This means that although margins on some products are low, the producer will keep running for as long as his net margin across all his output is positive.

Second, the economics of wells varies enormously across a region, even with the same producer. Producers are able to maximise their input to those wells that deliver the best cost outcome. Although there are some wells whose cost of production is as high as $90, there are plenty more that can operate below $50 a barrel cost.

What it means is that we are probably close to a ceiling on the price of crude oil. Moreover, as shale oil extraction technologies continue to improve and producers continue to drive their average costs down, that reduction in cost will translate into downward pressure on crude oil prices.

OPEC therefore, may need to reconsider the wisdom of their current strategy.  If crude is going to stay at or below $50, it puts enormous pressure on high cost producers inside the Middle East, many of whom are almost entirely reliant on oil for their economic health.

Meantime, the aluminium industry will come under increased pressure because of the increased shale oil production and the downward pressure on crude price. Not just because of the indirect macro linkage between the price of aluminium and the price of energy, but because more and more crude oil passing through oil refineries in the Gulf Coast will come from shale plays, and shale oil delivers a poorer quality petcoke, and much less of it. In fact, refiners will start to reconsider their coking economics completely.  According to the RBN report, America is entering an era of crude oil abundance. But it equally can be said that the aluminium industry is entering an era of coke tightness.

Acknowledgements to RBN, www.rbnenergy.com.


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