The 2014 Saudi oil policy change


Historical oil prices

Following the Second World War the 1950’s and 60’s were characterised by a long period of relatively stable, low oil prices. The international oil companies (the “seven sisters”) had significant influence on the price of oil but competition ensured that the oil price was closely linked to the actual cost of oil on a global basis. The ease and low cost of oil transport precluded large differences in oil prices across the world. The market share of Middle East low cost production areas gradually increased. The secure supply of low cost oil greatly contributed to post war economic growth.

A sharp divide exists between this period and the period after the first oil price shock in 1973. Post 1973 prices have been systematically higher and more volatile. Initially, oil prices were effectively set by the OPEC cartel. After the 1979 second oil price shock OPEC found, however, that there were limits to their ability to set prices. High prices led to increasing energy efficiency and new supply from higher cost non OPEC areas. Throughout the early 1980’s OPEC and its key member, Saudi Arabia, had to reduce production in order to support prices. By 1986, Saudi production had decreased to about 3.5 million barrels per day (with a total capacity of about 10 million barrels per day). They threw their hat in the ring and opened up the taps. For the Saudis this has been a defining moment.

fig 11


From 1986 to about 2002 oil prices were systematically lower compared to the 1973-1986 period. They did not return to the low levels of the 1950’s and 60’s, however. In the long run, a lower floor for oil prices was set by the incremental cost of non OPEC oil. The marginal cost of non OPEC oil was (and is) significantly higher than the marginal cost of OPEC oil. Although prices may temporarily drop below this level, the resulting drop in investments (whether in short lead time infill wells and re-completions or in long lead times new field developments) will ensure that this will only occur for a limited amount of time. The limited influence of oil price on demand, as well as the time it takes for new oil field developments (of the order of magnitude of 10 years) implies that readjustments may take a significant time.

From 2002 onward oil prices returned to higher levels. The reason for this was twofold. The prolonged period of lower prices resulted in a higher OPEC market share and hence more leeway to keep prices above the long term floor determined by incremental non OPEC oil. In addition the cost of incremental non OPEC oil gradually increased over time. Although there is no shortage of oil in general, there is a real shortage of cheap and easy to find oil in the non OPEC world. The cost of incremental non OPEC oil gradually increased from approximately $ 25 – 30 (2015 dollars) in the 1990’s to approximately $ 50 – 60 a barrel at the present day.

With the exception of a short period of turmoil related to the global economic crises in 2008 this period lasted until 2014. Again this period of relatively high oil prices resulted in relatively high investments in non OPEC oil with a threat of oversupply looming over the horizon at the end of this period. By 2014 Saudi Arabia (whose dominance within OPEC had increased over the years) faced the same choice as in the early 1980’s: defend market share or defend price? In the early 1980’s they chose to defend price. After 5 years they found that keeping oil prices at a level way beyond the cost of incremental non OPEC oil was simply not sustainable. Worse than that: it subsequently took 15 years to recover. This time they reacted differently.

Saudi Arabia

Within an often unstable Middle East Saudi Arabia has so far succeeded in maintaining its stability. A stability that should not be taken for granted given the internal Sunni Shia divisions and the strained relations with surrounding Shia countries, in particular Iran. The house of Saud has remained firmly in control. The Saudi population has preferred generous handouts and stability above democracy and instability. Given the countries essential role in oil supply the US and the western world have opted to look the other way when it came to human rights, democracy and religious fundamentalism. The special U.S. – Saudi relationship has been eroded, however. The U.S. is well aware that most 911 terrorists were Saudi. The U.S. is no longer dependent on Middle East oil. The Saudi government has been taken aback by the Iran nuclear agreement, the Obama administration’s lack of support for their long time Egypt ally and their limited support for regime change in Syria.

Undoubtedly the king and royal family have the last say in anything that matters within the kingdom but regarding oil they have a track record of following the advice of the technocrats that run the Ministry of Petroleum and Mineral Resources and Saudi Aramco (a haven of efficiency in a desert of inefficiency). For the last 50 years the Ministry has been headed by 3 ministers only (Ahmed Zaki Yamani, Hisham Nazer and Ali Al Naimi). Their strategy has been consistent: to maximise Saudi Arabia oil revenue in the long term. This is not just about price; it also implies contributing to oil remaining a key energy source for the world and being seen as a reliable source of supply. Within OPEC they have been a source of moderation. Their dominance has gradually increased within the organisation. Not only are they the largest producer but they have also consistently aimed at maintaining a spare capacity of on average about 2 million barrels a day. This spare capacity gives them the power (by no means unlimited) to act as the world’s swing producer and to preclude price spikes (due to financial crises or geopolitical turmoil). The kingdom’s strong financial situation enables them to give preference to long term goals (market share, revenue) at the expense of short term revenue maximisation.

fig 12

The second half of 2014 saw a dramatic fall in oil prices from about 100 – 110 US$ to about 50 US$. The last time such a dramatic fall occurred was in 2008/2009, following a sudden drop in demand related to the global economic crises. At that time OPEC, led by Saudi Arabia, continued to fulfill its role as the world’s swing producer and reduced production by 3 – 4 million barrels. This time, Saudi Arabia acted differently, culminating in the November 2014 OPEC decision (forced upon OPEC by Saudi Arabia) to keep OPEC production unchanged.

Oil supply and demand: a precarious balance.

Numerous headlines on the present day oil glut may give the impression of a large difference between supply and demand. This is not the case; at present (late 2015) we see an oversupply of about 1 – 1.5 million barrels/day, compared to a total supply of about 96 million barrels a day. That such a limited oversupply (perhaps considered minor in other markets) can have such a large effect on price illustrates the low price elasticity for oil in the short term. Lower prices will result in some instantaneous higher demand (e.g., people driving more) but it takes time to have a more material effect (e.g., people driving more gas guzzling SUV’s instead of fuel efficient small cars). In the same way lower prices will have a limited effect on immediate production (less workovers, infill drilling, with a response time of order of magnitude 1 year) and a larger effect in the long term (less new field or play developments, with a response time of order of magnitude 10 years). Note that in general, once a field has been developed or a well has been drilled, it will keep on producing (operating costs being relatively low compared to the oil price). Companies or countries in financial distress may even have an incentive to produce as much as they can.

fig 13

Oil price predictions are made on the basis of predictions of oil supply and demand, on our expectations of the willingness of a country like Saudi Arabia to act as a swing producer, on our expectations on political stability in countries like Iraq, Iran, Algeria, Venezuela, on our expectations of the determination of countries to limit emissions (just to name a few). Many of these items carry significant uncertainties. Saudi Arabia may change policy. Iraq may descend into chaos. U.S. shale oil production may be much more resilient than expected. This, combined with the large price implications of a limited mismatch between supply and demand, implies significant uncertainties. This is especially the case during periods without a swing producer that can react within months (if not weeks). We cannot say that “the oil price will definitely stay low for a prolonged period of time”. We may expect it perhaps (and plan accordingly) but should not underestimate uncertainties.

The 2014 price drop is Saudi driven.

For a prolonged period of time Saudi Arabia (with varying levels of support from other OPEC members) has acted as the worlds swing producer for oil. The figure below shows a marked correlation between changes (on a year on year basis) in Saudi oil production and oil price. The correlation is striking. Oil price changes (e.g. the 2008-2009 price drop) are followed by changes in Saudi production within 1 – 3 months (e.g. the 2009 reduction in production). Without Saudi Arabia playing the role of swing producer the small oil price elasticity would have resulted in a much more volatile oil price. The close correlation breaks down in mid 2014.

fig 14

The 2014 oil price drop (triggered by a limited amount of oversupply at the time) is not due to Saudi Arabia increasing production. Rather it is due to their refusal to cut back production and continue in their role as swing producer, in anticipation of a much larger oversupply predicted for the coming years (see below).

The oil price drop was not related to a large Saudi oil spare capacity hanging above the market. At the time Saudi spare capacity was close to the long term aspired average level of 2 million barrels / day (deemed to be the optimum compromise between maximising revenue and being able to play their role as swing producer). What is also apparent is that in 2014 non Saudi spare capacity in OPEC had become very small. The 2014 price drop is a Saudi driven event (with support from the UAE and Kuwait whose interests tend to be aligned).

fig 15

The precedent for the current price drop is the 1986 price drop. What is different is that in 2014 the Saudi government reacted much quicker, in anticipation of an expected period of oversupply whereas the 1986 price drop followed a long period of decreasing Saudi oil production.

Why did the Saudis change policy?

Being the swing producer is not a goal in itself. It is a way of limiting volatility (contributing to oil being seen as a reliable source of energy) and avoiding prices that are either very low (overly hurting revenue) or very high (hurting global oil demand and Saudi market share, and in the long term likely to result in lower prices). The long term goal is to maximise Saudi oil revenue (although geopolitical considerations and internal stability provide boundary conditions).

I see a number of reasons why the Saudis decided in 2014 that it was in their best long term interest not to reduce production:
– a slowdown in oil demand growth, perhaps more so then initially expected. Demand forecasts, such as those provided by the IEA, have tended to be revised downwards over the 2010 – 2015 period.
– a significant increase of oil supply expected over the 2015 – 2020 period (especially if oil prices would remain high). FID for these projects was often taken in 2005 – 2010.
– the advance of unconventional shale oil production in the US over the 2010-2014 period (a game changer).

These three factors are all of a more structural, long term nature. For more short term issues (e.g, a temporary drop in demand related to a financial crises as it took place in 2008, a temporary drop in supply due to political instability) the Saudis might well have been willing to continue in their role as a swing producer.

With Saudi decision making shifting to the hands of a younger generation the appetite for bolder steps may also have increased (e.g., Yemen military intervention). Geopolitical concerns (Russia, Iran) and long term climate concerns (with resulting falling demand) may play a role as well but do not seem to have taken the centre stage. The unwillingness of other OPEC and non OPEC (in particular Russia) producers to reduce production made it easier for Saudi Arabia to take this decision.

Slowdown in oil demand growth.

By mid 2014 the slowing down of oil demand growth, related to weak economic growth in Europe and China, became more pronounced. Oil demand in the OECD has been near constant for a long time due to increasing efficiency combined with limited economic growth. The slowdown in China is more significant, pointing at a gradual but important and long term change from a more rapidly growing energy-intensive economy to a more slowly growing less energy-intensive economy. This has far reaching implications for long term oil demand. At some time other Asian countries, in particular India, may experience a similar period of large energy demand growth as experienced by China over the last 15 years. This has not yet materialised in earnest and it may well turn out that a less well managed Indian economy may not be able to replicate what happened in China. For the long term future, it is becoming increasingly clear that climate concerns (and the resulting advance of renewable sources for power generation, electric vehicles) will affect demand.

Oil supply expected to increase significantly in 2015-2020.

Global upstream oil and gas investment increased from just over 250 billion dollars in 2000 to close to 700 billion dollars in 2013. This investment cycle started in the early 2000’s and boomed from 2010 onwards. In spite of all the problems commercial oil and gas companies have been facing regarding reserves replacement these efforts did eventually bear fruit. Partly in the form of reduced decline rates for existing fields and partly in the form of new developments (deepwater, oils sands). Whereas the first component tends to have a shorter lead time in between FID and production, the second component tends to have a much longer lead time (of the order of magnitude of 10 years).

fig 16

A 2012 bottoms up analysis of worldwide upstream projects (Maugeri, 2012) showed that, assuming a 2020 Brent Oil price higher than $ 70 per barrel, 2020 liquids production capacity was expected to increase to over 110 mb/day (from about 93 mb/day in 2010). The largest increase in production was expected in the US, Canada, Brazil and Iraq. This estimate took into account technical and political risk factors (the unrisked estimate being over 130 mb/day) and should be seen as a best estimate at the time, with a large uncertainty band around it (depending on the oil price, cost levels of the oil service industry, political stability in various countries, etc). Nevertheless it started to become increasingly clear that for a continuation of the high oil prices of 2010 – 2014, and potentially even for a moderate oil price of $ 70 a barrel, a severe oversupply could exist by 2020 (the average yearly growth in oil demand needed to keep up with the base case oil supply was 1.6 %; in excess of the average observed growth over the last 20 years).

A similar analysis by Rystad Energy (2014), based on their proprietary UCUBE database (a database of existing and future oil producing assets), also pointed to higher growth of supply, compared to demand, in the 2015 – 2020 period.

Rystad 2014 fig 17extra

US shale oil production has taken off.

Three out of four countries with the highest expected 2011 – 2020 capacity growth are located in the Western Hemisphere. The most remarkable component of this is the rapid growth of US oil input – solely due to shale oil production.

Fraccing has been practiced in the US since the 1940’s. The first large scale attempts at shale gas production were in the 1990’s in the Barnett shale in Texas by a smaller independent company (Mitchell Energy). It is only since 2010 that shale oil production from fracced horizontal wells has really taken off. The key contributing factors have been:
– A prolonged period of high oil prices
– US legislation, with mineral rights being privately owned
– Funding readily available to smaller independent producers, at a relatively small cost
– Sweet spots for shale oil production known from the large numbers of existing wells
– The existence of a large, relatively low-cost and knowledgeable service industry
– Public acceptance of the industry (in particular in key shale oil production states such as Texas)
From a technical point of view this has been a remarkable achievement. The gains in efficiency have been impressive and may – as yet – not have reached a plateau.

The success of the US shale industry will be difficult to replicate but it is not a given that a similar take off of production will not take place in other parts of the world, at some stage (e.g. Argentina, China). Once that a critical level of production, experience and service industry activity has been established it will be virtually impossible to stop.

fig 110

Shale oil production has a number of characteristics that are markedly different from the mainstream oil and gas industry:
– The shale oil industry is using manufacturing-like processes. Many wells are drilled / fracced using the same process in similar locations. As with many processes that are oft repeated: this eventually results in strong productivity gains.
– Oil in place is less of a limiting factor compared to conventional developments. Vast amounts of oil in place exist. Oil in place in specific sweetspots may be a limiting factor but so far increased efficiency has beaten limited amounts of oil in place in the sweetspots. The verdict is still out on how this will continue in the future.
– Decline rates for shale oil wells are much faster, with on average about 60 % of total production achieved in the first year of production.

US shale oil production responds relatively quickly to price changes. Provided that oil transport and infrastructure is available the lead time between FID and new production is of the order of magnitude of a year only. This is similar to the lead time for infill wells and workovers in the conventional industry (but much faster than the lead time of new developments). Although US shale oil lead times are at the low end of the oil industry lead time range they do not enable to the shale oil industry to take over the role of swing producer from Saudi Arabia.

The Saudi policy shift: will they succeed?

The resulting oil price drop is undoubtfully painful for Saudi Arabia (but with a low Saudi Arabia oil production cost of $ 5 – 6 per barrel less painful then for other higher cost OPEC producers). Saudi Arabia’s financial position (e.g., net foreign assets of about $740bn (mid 2014) and minimal debt) has given them a good starting position for a period of low oil prices. By mid 2015 foreign reserves had decreased to about $650bn and they had started to take on debt. Other OPEC members (in particular Venezuela, Nigeria) are in a much more difficult position.

fig 111

The dramatic increase in shale oil production has undoubtedly played a key role. Continued high oil prices in excess of 100 barrels / day would have likely resulted in a further explosion of US shale oil production and – even more worrying – would have increased the scope of shale oil production in other parts of the world.

Nevertheless this is not a Saudi war on US shale oil production. It is aiming for increasing market share in the short term. This is seen as the best policy in the current market conditions to maximise Saudi oil revenues in the long term (the long term goal that has not changed). High cost oil production in other parts of the world needs to be reined in. If anything it is now a battle between US shale production and other high cost production areas, be it Canadian tar sands, deepwater, the Arctic or conventional mature fields (e.g., North Sea). Seen in this light the recent U.S. rejection of the Keystone XL pipeline may not have just been driven by environmental considerations. A battle for survival, following a forceful reminder that Saudi Arabia will not always bail out high cost producers by putting a floor to the oil price.

In order to (gradually) go back on their current policy I would expect that the Saudis would like to see:
1. Supply to have fallen below demand
2. Inventories to have reduced to – or at least to approach – average long term levels
3. Confidence that a sufficient number of projects have been cancelled / postponed so that future oil supply is unlikely to exceed demand in the short and medium term
Even then they are more likely to (at least initially) aim for a $ 60 – 90 per barrel bracket. Their limited spare capacity may limit their power to preclude higher prices though.

In my view the Saudi efforts have a good chance of succeeding. They have been much more pro-active than in the 1980’s; not waiting for market share to collapse due to high prices. No excessive Saudi spare capacity exists at the moment (if anything it is lower than the long term average following a moderate increase in production in early 2015). The price of non OPEC incremental oil is significantly higher now. They seem determined (and have the financial resources) to see this through 2016. By 2017/2018 they should have made sufficient progress to let prices rebound. Should this require a limited drop in oil production then they will probably try and share that with other OPEC producers and Russia (with better chances of success than in 2014). Until that time they should give no early signals of a change in course, in order to maximise the drop in current and future non OPEC supply. This would leave Saudi Arabia with a much improved starting point for the challenging years ahead with likely long term limited demand (reduced economic growth, increasing energy efficiency and the fallout of climate concerns).

Significant volatility in oil prices is there to stay. The world will likely face a prolonged period of relatively low demand (although it is uncertain how this will pan out), giving a long term downward pressure on oil prices. To what extent will renewable power generation and electric vehicles take of? Reserve replacement in the non OPEC world remains a challenge for oil companies, giving a long term upward pressure on oil prices. To what extent will shale oil production take of outside the U.S.?

In the meantime instability in the Middle East remains a source of concern. More intense Sunni – Shia divisions, mass youth unemployment and the partial US withdrawal from the region (the US now being close to energy independence) all play a role here. Will Saudi Arabia itself remain stable, now that the long reign of King Abdullah has ended and caution and diplomacy seem to have been replaced by assertiveness and paranoia? Will the current crown prince and deputy crown prince fall out? Severe supply disruptions and resulting price hikes are conceivable. On the other hand: what happens if Iraq and Iran low cost production really takes off in earnest? In the long term this could result in OPEC having three key members instead of one. Will these three countries be able to reach an agreement to limit their production? If not then we could see low oil prices for real.

In conclusion

In the light of limited future oil demand growth as well as the rapid recent increase of US shale oil production and the expected increase of conventional oil production (following years of high investment) the 2014 Saudi policy change seems perfectly sensible.

Defending oil price at a level much higher than the cost of incremental non OPEC oil is simply not sustainable in the long run. As in the 1980’s, this would only result in a reduction of market share followed by a more prolonged subsequent period of low oil prices.

Saudi Arabia has the financial resources to continue the current policy for several years. It seems likely, however, that by 2017 or 2018 they will have achieved their short term goals: supply to have fallen below demand, a start of inventory reduction and confidence that sufficient projects have been cancelled so that supply is unlikely to exceed demand in the medium term. By that time they may aim for a $ 60 – 90 per barrel bracket.


Selected further reading

Historical oil prices:

Daniel Yergin’s the Prize The Prize and The Quest give an extensive overview of the history of the oil industry

A historical overview of OPEC and its pricing power can be found in OPEC: what difference has it made (2013) (Oxford Institute of Energy Studies).

Saudi Arabia:

Paul Aarts and Carolien Roelants give an up to date country overview in Saudi Arabia: a kingdom in peril

Saudi Arabia oil policy is discussed in this report from the Oxford Institute of Energy Studies  

An overview of Saudi Arabia internal stability issues can be found under Jane’s Saudi Arabia country overview

The BBC’s security correspondent, Frank Gardner, has published a number of articles on Saudi Arabia’s increased assertiveness

Oil supply and demand:

The IEA and EIA regular updates on oil supply and demand. For short and medium term oil supply forecasting I prefer the site from Rystad Energy which tends to be relatively open and and transparent on their forecasting (in contrast to many of the other consultancy firms). There is no substitute for building a global database on oil fields and prospects (with break even prices, etc), however laborious it may be (and crude at an individual asset scale). Their UCUBE upstream database has a free, simplified version. The upstream database in Maugeri (2012) is much more simple but the authors experience as a VP in one of the international oil companies (and currently one of Saudi Arabia’s external advisers) adds interesting insights.

US shale oil:

A recent overview of the rapid changes in the US oil and gas industry can be found in this Citi report.

An overview of ongoing developments in US shale oil can be found in Maugeri (2013)





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