The Sultans of Swing
Saudi’s Swing Bubble to burst US tight oil?
Saudi Arabia’s attack on the oil price was entirely predictable, says NewsBase Research (NBR), whose Global Oil Forecast predicted the current price crash in July 2014 using its proprietary forecasting model. Exclusively for FT Energy Strategies Summit delegates, NBR can reveal the thinking behind Saudi’s strategy as they aim to protect control of their “Swing Bubble”.
THE sustained fall in the oil price is causing political and economic shockwaves around the world, throwing corporate plans and investment strategies into disarray, with Saudi Arabia the driving force behind the crash.
Late last year, the commentariat brought forward a miscellany of reasons for Saudi Arabia’s attack on the oil price, most of which conflicted with each other. A common theme has now emerged that Saudi is attempting to take the wind out of the US tight oil industry’s sails.
But how long will the attack last, and what will be the long-term
impact on US tight oil and the wider industry?
To answer this question, we must uncover the motivations behind Saudi’s strategy. In our Long-Term Outlook Annual Forecast written in July 2014, we wrote:
“We expect Saudi to create price volatility through periods of over- and under-production, in order to discourage investment in Industrial and unconventional Liquids – especially US tight oil.”
We referred to this strategy of periodically creating strong negative disequilibria, and therefore price declines, to discourage investment in US tight oil as “Psych Spikes”. In our view, around six months of acutely low prices are probably sufficient to make a substantial change to the risk perceptions of capital allocators, raising hurdle rates for new projects and so taming (but not killing) investment.
There is clear evidence that the Psych Spike is having an effect. Permits for new oil and gas wells fell by nearly 40% across the US at the end of last year, and rig counts have plunged dramatically since the beginning of 2015.
We expected Q1 US tight oil supply to continue to rise, but to level off in spring and early summer before showing month-on-month declines in H2 2015. EIA figures in recent weeks have confirmed that this decrease is happening, with US tight oil production now suffering its first aggregate drop in four years. So what was the thinking behind Saudi’s strategy, and what are the long-term effects on US tight oil production?
Between 2005 and 2014, global conventional (geological) supply fell by nearly 4 mbpd, from 73.3 mbpd to 69.6 mbpd. Over the same period, demand rose from 84.4 mbpd to around 91.5 mbpd. After the collapse of 2008/9, sustained demand recovery drove prices up from $35 to $128. Steadily rising prices created space for tight and Industrial Liquids to meet the growing demand, while Saudi carefully managed the market equilibrium to ensure prices did not climb at damaging rates.
One result of this strategy was to finance a rapid increase in North American tight oil production to 5 mbpd by the end of 2014, accounting for almost all net supply growth since 2010. The graph on page one illustrates this little-acknowledged truth.
We have no doubt that Saudi Arabia is anticipating global supply and demand trajectories well ahead of events in order to keep control of its Swing Power.
To do this, it must keep control of its “Swing Bubble” – a zone of swing capacity of roughly 4 mbpd neatly positioned over the market’s prevailing supply/ demand equilibrium point.
Saudi’s need to “Keep the Bubble” can conflict with its Minimal Acceptable Production Level (MAPL), defined by domestic budget and energy needs. As long as it can keep MAPL within the Swing Bubble, Saudi can manage world prices to suit its agendas.
The size of the Swing Bubble is a function of MAPL on one side and Saudi’s maximum sustainable production level (SaudiMax) on the other. Combined, these reveal a surprisingly narrow production zone in which Saudi can maintain strong influence over prices, and so keep the Bubble balanced (details of this are provided to NBR clients in the NBR Global Oil Forecasting Service).
In a Positive Disequilibrium with the Bubble below the line, global demand outstrips supply and Saudi at maximum production cannot produce enough to maintain stable prices: this results in a spike in oil prices and accelerating substitution of alternative fuels. If the Bubble goes above the line, Negative Disequilibrium sees supply outstrip demand and prices fall. Saudi’s state budgets come under threat, depleting its sovereign wealth fund (SWF) and threatening the state’s ability to keep providing for its population. Saudi does not want an Arab Spring in its Majlis.
NBR’s 2014 Long-Term Outlook, written in July 2014, identified a period of six years starting in 2017 during which trajectories of global supply and demand would almost certainly see Saudi lose the Swing Bubble in a Negative Disequilibrium environment. We calculated that the looming crisis flowed from a likely structural disequilibrium of around 1 mbpd of oversupply in the market in 2019.
Losing the Bubble for those six years would be very painful for Saudi. Our budget analysis shows that its cost over the six-year period would likely be in the region of $200bn, or roughly one quarter of Saudi’s SWF today. We predicted that Saudi would be willing to suffer brief periods of SWF divestment to balance the market, but not on the scale required over 2017 to 2023.
The central insight from our analysis is that Saudi can keep the Bubble by removing just a single millions barrels per day from global production over 2017 to 2023. This small win (just over 1% of global production) would allow Riyadh to avoid SWF divestment over this period.
The easiest place to realise this aim is to target growth in US tight oil supply.
The Psych Spike effect on US tight oil
Tight oil flows respond to CAPEX flows quickly and powerfully, both up and down. This makes tight oil production flows much more vulnerable and responsive to short-term price fluctuations than conventional and other Industrial supply sources.
Our analysis suggested it takes six months for lower prices to begin hitting actual tight oil production.
This inertia flows from the timing of drilling permits (generally acquired two to three months before drilling starts), and the time needed for drilling and completion. We also discussed earlier that six months of acutely low prices was probably sufficient to make a substantial change to risk perceptions of capital allocators.
Both of these views have played out since the beginning of the crash. The news flow in 2015 has been populated with announcements of CAPEX cuts (six months after the price attack started), and US tight oil production is only starting to decline, when we said it would.
Two features can be seen in the graph above: first, US tight oil will suffer a short fall in production, of 1-1.5 mbpd, for about a year as financial capital flows are scared out of the tight oil market. We are currently seeing the start of this fall. Secondly, and more importantly in the context of Saudi’s goals for 2017 to 2023, US tight oil will rebound but with peak production 1 mbpd lower than it would have been without the price attack.
With the price attack costing Saudi $7.5bn per month in 2015, and with its goal achieved of removing the top 1 mbpd of tight oil from the market, we expect to see Saudi starting to ease off the attack in 2015. Prices will remain volatile, but trend upwards over the course
of the year. We have already seen prices rise from $50 to nearly $64 in late February before dropping back down to $55 in late March. At the end of April, Brent was back up to around $66.
We expect that the price slump will therefore be too short to have any long-term effects on conventional oil supply, with projects planned over decades on a built-in assumption that prices will be volatile at times. Whilst some projects will be delayed, the effects of those delays will not be felt for a decade or more and will be very small when they do arrive – taking less than 0.5% out of production in any given year. Other unconventional projects, such as Canadian oil sands, will also only see a short and small pause.
Despite forecasting that prices will trend upwards over 2015, we believe the continued volatility in the price will prevent capital allocators from piling back into US tight oil as readily as they did before. If they do, and forecast tight oil production returns to pre-Psych Spike levels, we believe Saudi would repeat the dose to trash the price again.
Saudi’s Swing Bubble forms a small but important part of NBR’s forecasting model. To learn more about the different facets of the model, and how we forecast future supply, demand and price pressure zones, please contact email@example.com or call Andrew Langlands, Vice President Sales, on +44 (0)131 478 8543.
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