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2014-10-25 00:00:00



Oil prices have fallen by over 20% in the last couple of months. Brent is currently trading $30 below its summer spike to $115 per barrel and many are left wondering what the Saudis are playing at. Based on conventional wisdom, past moves and motives, Saudi Arabia should lower production to stem the oil price decline.

Yet there is nothing conventional about what we are witnessing in the market. The world's largest net importer of crude oil is now China, a crown the US was not unhappy to give up earlier this year. Rising domestic production has meant the US is buying less from the global market leaving China with more clout and negotiating leverage. Worse still, Chinese demand at present is not quite what it used to be. A stronger dollar is weakening the oil price too.

In this unconventional climate, Aramco, Saudi Arabia's national oil company, stirred things up earlier this month not by cutting production, but by lowering the price of its flagship Arab Light crude oil for Asian contracts by $1 per barrel. Indignant though they were, the Iranians followed their great OPEC rival in cutting their sale price too.

While the world was focused on Brent and WTI price dips, the OPEC Reference Basket of twelve crude oils from its member countries slipped from $89.37 on 7 October (just days after the Saudi move) to $81.67 per barrel on 23 October. Popular discourse about Saudi motives seems to be that oil minister Ali Al-Naimi does not want to see a repeat of the 1980s when cuts in production saw his country lose global market share.

Many think the market is forcing the Saudis to react in the way that they are. That's too simplistic an explanation to accept. On the contrary, I think rather than the market playing the Saudis, it is they who are playing the market with some deftness. Self-preservation might well be the motive, but it has many facets rather than a singular aim of maintaining market share.

I strongly believe the Saudis are taking a short-term hit to bolster their long-term objective of remaining powerfully relevant in the global oil markets. Al-Naimi could have acted to protect $100 price floor, which Saudi Arabia needs to balance its budget but felt no need to. The country can draw on a substantial stock of assets that would enable it to withstand lower oil prices for a sustained period without necessarily needing to borrow or tighten policy, according Robert Burgess, analyst at Deutsche Bank .

Within OPEC, only Kuwait (needing a breakeven price of $75), Qatar ($71) and United Arab Emirates ($80) can withstand the current oil price decline along with the Saudis. However, others would be left sweating. For instance, Venezuela needs the price to be an unrealistic $162. Iran needs $134, Nigeria $126 and non-OPEC producer Russia around $100. Of the four, Russia can withstand the price decline for now, but persistently low prices will start biting.

Economic growth in the sanctions hit country is already sluggish. Additionally, oil and gas account for 70% of Russia's exports and 50% of its federal budget. Its stock of assets, while healthy, is about a third of what Saudi Arabia holds. Furthermore, Saudi Arabia's decision not to decrease production also has the potential to hit shale and tight oil exploration in the US and oil sands exploration in Canada.

Feedback from industry contacts in North America suggests shale oil plays remain profitable at an oil price of around $90, while the Canadian oil sands remain profitable around $75. Both Brent and WTI futures prices are well below $90 and not far from $75. In the case of shale, you have to keep drilling to maintain output levels as the production decline rate does not follow the patterns of conventional plays.

Furthermore, lower prices hurt western exploration and production (E&P) companies' revenues immediately, with most of the drop falling straight to the bottomline because of their high operating leverage, says Steve Wood, managing director at Moody's.

The oil price could fall below $70 over the coming months before eventually recovering; so the situation will worsen before it gets better.

"It's hardly shocking that oil prices have weakened in the face of growing supply. But the sharp [mid-October] drop has been surprising and can be attributed to expectations of weaker demand growth in China and Europe at the same time that Saudi Arabia has threatened to defend market share rather than acting as OPEC's – and the world's – swing producer," Wood adds.

To put things into context, during the last oil price crash at the height of the financial crisis in 2008-09, that swing producer made the biggest contribution to OPEC's production cuts of nearly 5 million barrels per day in a bid to boost prices. Its reaction so far into the current price correction hasn't been anything like it and for good self-preserving reasons.




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