From the beginning of floating the idea of an oil production cut deal with OPEC, Russia, and some other miner oil producers, I’ve been against it, and frankly, surprised that it was initiated and consummated in the first place.
At issue was the emergence of U.S. shale producers that were able to become more efficient while boosting production. Also a factor was the new way of drilling which allowed producers to drill but not complete wells (DUC wells), which essentially was a way to store oil without sending it to a traditional storage facility. It was also a way to rapidly respond to favorable market conditions when they presented themselves.
A couple of years ago officials from Saudi Arabia even mentioned they had no idea what to do if they engaged in production cuts to support the price of oil, which would trigger an increase in oil production from shale companies operating in the U.S.
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So when the decision was made to enter into a production cut deal, it generated a lot of suspicion within me as to the motives behind it. At face value it appears it was only to support the price of oil, as the sovereign wealth fund of Saudi Arabia in particular was shrinking rapidly, as the country scrambled to cut back on perks it gave its people for a long time in order to slow the decline.
Essentially, what Saudi Arabia and others were gaining in margins, earnings and cash flow per barrel, they were losing in overall sales; at least those that had even cuts in place to make a difference. Saudi Arabia was by far the most exposed to the cuts in that regard.
Now there is growing concern among some that if the price of oil continues to climb, it could trigger a global recession.
Why the cuts may have came when they did
There was some irrational exuberance concerning the potential of shale growth in the long term, although even today there are discrepancies in outlooks by the EIA, IEA, and OPEC, among others, as to how high the price of oil will go, how sustainable it is, and how much more U.S. shale production will grow, and how quickly.
I think the reason Saudi Arabia pushed for the cuts when it did – which were probably demanded behind closed doors by U.S. and European officials – is shale producers decided to boost production and lower costs by targeting the best wells they had. The idea was once the premium wells were in production, the wells, which don’t last near as long as traditional wells, would eventually start to decline, and they would likely be irreplaceable.
By continuing to extend the length of the production cut deal, it has given time to see if that’s how it was going to play out. Some believe we’re already in the middle of that transition, while others believe shale production is going to continue to soar for some years.
Another strategy that was obvious to me is Saudi Arabia and others participating in the deal were also looking for global oil demand to rise enough to catch up with increase in shale production, so when the deal was exited, there would be minimal impact on the price of oil. To this day how there will be an exit from the deal is a huge question.
What I’ve read is they’re looking at some type of managed exit. What that means is in reality, it won’t be an exit at all, but presumably a readjustment of the size of the production cuts. In other words, they’ll probably gradually lower the cuts until they disappear. The idea here is the pace of shale production is expected to slow down because of declining production from premium wells, while global oil demand continues to increase.
Under that scenario, the price of oil, theoretically, won’t experience a sharp decline, bringing things back to where they were when the production cuts were made. The level of success with this will be determined by how resilient shale production really is. We’re probably going to find out in 2018, and by latest, the first half of 2019.
What if Saudi Arabia wins
There’s a major problem with all of this that most of the market hasn’t taken into consideration, and that is that recessions since oil has been a big factor in the global economy – approximately two generations – have all been proceeded by a significant upswing in the price of oil.
I don’t believe oil at about $65 or so is going to trigger a recession, but if it starts climbing past $70 per barrel and higher, it could become a major catalyst toward that end.
At that time will the U.S. and other developed nations basically tell OPEC and other participants to knock it off, or as I mentioned earlier, are they behind the pressure put on the producers to make the deal in the first place?
In one way of looking at it, this could be considered an act of economic war on the U.S. and other nations, depending upon who it was behind the reason for the cuts.
I’m not saying this is a conspiracy, only that the steps made by Saudi Arabia and others, in light of the strong U.S. shale industry, made no strategic, economic sense whatsoever.
At this time it appears it has started to work, but lowering oil production is one thing, exiting the production cuts is an entirely different issue, when considering whether or not it will be able to be done without crushing oil prices.
The stakes associated with oil production cuts are starting to rise. How much more will the production cuts be allowed to go on if they give signs of leading the world into a recession?
At the same time, what about OPEC and the others participating in the deal, whom may have to suck it up and admit they provided a better price environment for shale producers, while now having to give up propping up oil prices, putting pressure once again on sovereign wealth funds and perks from oil revenue?
All of this is happening while Saudi Arabia is scrambling and struggling to diversify its economy in order to prepare for the day when demand for oil starts to decline.
From the point of view of OPEC members located in the Middle East, this could trigger massive unrest if the social services and perks underwritten by oil revenue start to shrink rapidly and deeply. The tinderbox of the region would once again be ignited, causing massive unrest and upheaval; possibly revolution and regime change.
No matter what the pace of production growth coming from U.S. shale, it has to be understood that it is in fact the reason behind the downward pressure on oil prices over the last three years or so.
If the sector once again continues to surprise in performance, it could completely undermine the reason for taking the risk of the production cuts in the first place. Assuming that happens, any semblance of adherence to the deal would be quickly abandoned, and all the participants in the deal would produce at a level they deem is best for themselves.
In the meantime, the price of oil continues to find support, and I believe the key will once again be how rapidly shale production increases, offset by the pace of demand for oil around the world.
If oil continues to soar and shale isn’t able to offset demand and declining stockpiles, a win by Saudi Arabia and others concerning the price of oil will be an economic loss for the world, as it triggers another recession.
It won’t be the only catalyst, but it would be the initial domino that starts it all falling.