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Will the Saudis Cut Production? Does it Matter if They Do? Part 2

Brian Pellegrini, CFA, 27 October 2016

Key Takeaways 1. The historically-abnormal black hole of power created by ISIS1 in Syria will draw the region’s major

powers – and potentially some of the Great Powers – into increasingly intense conflict. We expect that prices will be very low until conflict – or fears of an imminent conflict – drive a dramatic spike in oil prices. We would summarize our view of price action as low, low, low and then very high.

2. The secrecy surrounding Saudi oil policy lends itself to narrative-spinning that the decision-making process is driven by family politics and personality rather than by economic considerations and a deep understanding of the oil industry. This is a mistake market participants would be wise to avoid.

3. Prudence dictates that Saudi production strategy remains one of maintaining a high level of production in order to maximize revenues via volume rather than cutting production in a futile attempt to pull the supply curve back far enough to move the intersection between supply and demand onto the steep portion of the supply curve.

4. Optimal Saudi production strategy can be assessed using game theory analysis. There are two potential game frameworks. In Game 1 the supply of shale is elastic on the upside so that shale drillers increase production in response even to small changes in the market price. In Game 2 drilling activity is inelastic and OPEC members are able to harvest gains from a cut to production. The problem for the Saudis is that have no way of knowing ex ante which game they are in.

A Flawed Narrative As discussed in Part 1 there is a widespread misconception of OPEC as an effective cartel led by Saudi Arabia acting as a dominant producer. We saw evidence in Part 1 that OPEC is a cartel in name only and that Saudi Arabia’s ability to act as a dominant producer is true only in situations where the oil market’s supply and demand curves intersect at a point close to the steep portion of the supply curve.

Fattouh (2015, April) points out that coverage of events in the Middle East is shaped by memories of the 1973 oil embargo, the only time OPEC can be argued to have acted as an effective cartel. Since 1973, media coverage and U.S. government policy have been dominated by a focus on security of oil supply. The inclination has been to view OPEC oil strategy (more accurately Saudi strategy) as being driven by geopolitics and international intrigue. The secrecy surrounding Saudi oil policy lends itself to spinning a narrative that the decision-making process is driven by family politics and personality rather than by economic considerations and a deep understanding of the oil industry. This is a mistake market participants would be wise to avoid.

1 See our notes “Obama, Putin and the Coalition of the 12

th Imam” and “Saudi Arabia: Sunni or Arab?” of 9 October 2015 and 23 December

2015, respectively.

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In this note we first examine the drivers of Saudi oil policy from a game theory perspective. We then discuss the price elasticity of U.S. shale production, the primary unknown parameter facing Saudi oil- policymakers.

Saudi Constraints One must begin by assessing the constraints faced by Saudi decision-makers. First, there is the obvious issue of a very high dependency on oil revenues for maintaining fiscal and external balance. Given the rapid depletion of sovereign wealth that has occurred since mid-2014, the Saudis cannot afford an extended experiment in price manipulation like the one they undertook (unsuccessfully) in the early 1980s. Former Saudi Oil Minister Ali Al-Naimi made that clear in saying in December 2015:

“[T]he experience of the first half of the 1980s was still in our minds. At the time, we cut our production several times. Some OPEC countries followed our lead, and the aim was to reach a specific price that we thought was achievable. It didn’t work. In the end, we lost our customers and the price. … We are not willing to make the same mistake again.”

Second, as discussed in our note “‘The’ Price of Oil: All Strategy is Local” of 11 February 2016, the idea of a unified global oil market is somewhat of a fiction because oil grades are only partially fungible. The Saudis produce a wide variety of grades of oil and as a result need to maintain a variety of customers across the globe. The Saudis are forced to compete in multiple isolated markets against producers that generally produce one or only a few grades of oil. These more focused producers are incentivized to fight more intensely for market share in their specific submarkets.

As discussed in the note mentioned above, Russia’s export decisions are highly constrained by its reliance on pipelines for transport. Russia has limited ability to focus on Asian markets for the simple reason that it has relatively little pipeline capacity headed east. Although the Russians have tanker export facilities in the Baltic and Black Seas, the Straits of Denmark and the Boshporus limit the size and number of tankers that can be used. Chart 1 below shows just how heavily Russia depends on Western Europe for oil revenues.

Like the Saudis, West African producers rely mainly on waterborne trade to bring their crude to market. However, unlike the Saudis, the major West African producers are endowed primarily with light sweet crude. As can be seen in Chart 2 below, these producers were unceremoniously pushed out of the U.S. market as shale production ramped up.

The upshot of all this is that the Saudis have to be very careful about which grades of output to cut. Any decision about cutting output of a particular grade must take into consideration the situation in rival producers of that grade. A production cut of a particular grade might be easily filled in by a producer with either new supply coming online or some flexibility of production capacity.

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Russian Crude Oil and Condensate Exports by Destination, 2014

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U.S. Oil Import Market Share: The Losers

Angola Nigeria

Sources: Bloomberg, Connolly Insight

Third, in an ironic twist, the Saudi government’s efforts to diversify away from crude exports by expanding into other industries – particularly downstream sectors - have made them more dependent on oil production. The reason is twofold. As discussed in Part 1, Saudi companies have become accustomed to subsidized energy prices and as a result are inefficient in their use of energy. In addition, downstream hydrocarbon product production has led to largescale development in industries dependent on feedstock from oil refining and natural gas production. Without cheap and abundant supplies of naphtha, natural gas and natural gas liquids, the Saudi “non-oil” sector would be crippled. Most Saudi natural gas production is associated gas that is a by-product of oil production. Cuts to oil production will mean cuts to associated gas production. That will mean either higher prices for domestic companies or larger subsidy payments to cover the cost of importing natural gas and refined products.

Finally, the Saudis have a massive supply of oil reserves that will last for 60-80 years at current depletion rates. It is in their best interests to avoid the forbidden fruit of encouraging major price increases to generate outsized profits in the short-term. As we shall see below, elevated prices from 2007 through 2014 has caused demand destruction and non-OPEC supply responses that cannot be entirely reversed via low prices. OPEC producers are paying dearly for the seven fat years that ended in 2014 and will continue to do so for the foreseeable future.

Given the difficulties low prices have caused for the Saudis, it would be a mistake to think the Saudis intentionally crashed oil prices to kill off shale producers or stage an economic attack on Russia and/or Iran. Rather, the Saudis have been working to react as best as possible to a difficult exogenous event that they have little control over.

A Game Theory View In a very interesting IMF Working Paper, economists Behar and Ritz (2016) create a game theory model that determines whether a Saudi policy of cutting production to “accommodate” rising production by other producers or increasing production to maintain their existing market share is optimal. They stress that choosing a strategy should be based on the relative benefits of alternative strategies given current market

1 2

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conditions rather than as an attempt to get back to favorable market conditions in the past. They find that a strategy of targeting market share is optimal given four conditions:

1) Slower demand growth 2) Rising production by high-cost producers 3) Reduced OPEC cohesiveness 4) Higher non-OPEC output

OPEC Cohesiveness Behar and Ritz found that it takes only a small reduction in OPEC cohesiveness to make the market-share strategy preferable because with low cohesion any cut by the Saudis will be filled in by increased exports by other OPEC members. As we saw in Part 1, the view that OPEC is an effective cartel is a “rational myth” so this factor argues strongly for maintaining production.

The difficulty of organizing a production cut is compounded by the potential for a significant volume of Libyan and Nigerian oil to return to market after a period of disruption due to sabotage and armed conflict. Chart 3 below shows the volume of unplanned OPEC outages. Libya and Nigeria currently comprise the bulk of the outages, which leaves a significant overhang in the event these two countries stabilize. Indeed, there are signs that may already be happening.

The “October” data for foreign production in the EIA Short-term Energy Outlook actually lags by two months. As a result, the unplanned outages shown below do not reflect an increase of 500,000 barrels per day by Nigeria as a result of ongoing negotiations with rebels in the Niger River Delta. Libya also increased output by 200,000 barrels per day in September and may be able to boost production by another 100,000 in October. While the conflict in Libya is far from over, NATO recently began providing military assistance to the UN-recognized government in Tripoli in an effort to tip the balance of the conflict. Oil exports are the only source of revenue for the government and Western powers will be keen to encourage bringing export capacity back online as quickly as possible.

3

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Disappointing Demand Growth Another factor arguing in favor of a market-share strategy is expectations for demand growth. Chart 4 below shows the annual increase in global oil demand. Beginning in early 2013 annual demand growth began decelerating rapidly. After the price crash began in mid-2014, demand growth accelerated, but in late 2015 consumption growth began decelerating again. It is important to note that actual demand growth has consistently underperformed relative to EIA and IEA projections since 2013.

Chart 5 below shows the IMF’s outlook for global GDP growth through 2021. Clearly, economic growth expectations are not measuring up to pre-crisis levels, which will have negative implications for oil demand growth. Readers of Bernard’s work will know our view that the IMF’s projections are grossly over-optimistic. We believe such over-optimism in global growth expectations means that market expectations for oil demand growth are also likely over-optimistic. Thus, demand developments prior to mid-2014 show that a market-share strategy was appropriate and the outlook for slow demand growth means that a market share strategy will continue to be appropriate.

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Global Oil Demand Change (y/y million bbl/d)

Sources: Bloomberg, Connolly Insight

Demand growth slowed more than expected before

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Global GDP Growth (IMF Estimate, y/y % change, 3yr moving avg)

Sources: Bloomberg, Connolly Insight

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Chart 6 below shows global GDP growth plotted against the real price of oil in 2015 dollars. This chart shows just how abnormal oil prices were in the period from 2008 to 2014, given the pace of global GDP growth. It is also important to note that prices relative to growth during that period were similar to the 1980 to 1982 period. As we shall see below, the period of high prices from 1979 to 1982 led to demand destruction and stimulation of competing supply. Both of these factors had serious negative consequences for OPEC. We believe a similar dynamic is playing out today. The data points in the yellow oval are also interesting because they show markets moving in different directions. From 1983 to 1985 prices were moving down to historically-normal levels while in the period 2005 to 2007 the demand curve for oil was moving onto the steep portion of the supply curve, leading to rapidly rising prices. In both cases the end result was that prices moved back to a historically-normal relationship between global growth and real oil prices, represented by the green oval.

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Global GDP Growth vs. Real Oil Price 1980-2015 (2015$)

Sources: BP, IMF, Connolly Insight

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Asymmetric Demand Response An important consideration when assessing the demand outlook for oil is the long-term shockwaves caused by the price spikes of 1979 and 2008. Charts 7 and 8 below show the development of intensity of oil demand in the U.S. for the periods 1971 to 1997 and 1998 to 2015, respectively. We can see that the two charts are strikingly similar. The implication of these charts is that the boost on the upside from demand caused by the cut in prices is likely to be lower than would have been the case prior to 2008.

In a study of demand responses to price changes, Gately (2001) found that OECD short-run oil demand is highly inelastic. The result is that for brief periods tight supply can result in major increases in OPEC revenue. Developments in the 1970s are highly pertinent here. By 1980 the real price of oil was more than five times higher than the level in 1973, as seen in Chart 7. OPEC misinterpreted this price action as meaning it could increase prices abruptly and permanently. OPEC’s mistake was to make incorrect parameter assumptions about the elasticity of demand. Not only was non-OPEC demand more sensitive to price increases than anticipated, but elasticity was asymmetric. The reason is that higher prices induce efficiency improvements, and alternative methods put in place during periods of high prices are not reversed when prices decline.

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U.S. Oil Demand Response to Changes in Oil Price (1971 - 1997)

Sources: BP Statistical Review, Bloomberg, Connolly Insight

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Sources: BP Statistical Review, Bloomberg, Connolly Insight

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Chart 9 below shows just how badly OPEC members shot themselves in the foot with their high-price policy in 1979 and again in the mid-2000s. We can see that in the early 1980s demand intensity in the U.S., Germany and Japan all decreased significantly. In Japan demand intensity did later increase as the country adopted a policy of burning raw crude for electricity generation, but in Germany and the U.S. demand intensity did not return to pre-1980 levels. We can also see that the U.S., Japan and the UK all experienced sharp reductions in demand intensity starting in the mid-2000s. Germany’s demand intensity had been declining steadily since 2000 so the effect was not noticeable2. Clearly an exercise of market power by the Saudis in the mid-2000s has led to negative consequences that cannot be easily reversed. The decline in demand intensity across the developed world provides an even stronger argument for a market-share policy that acknowledges the Saudis no longer have market power and makes the best of a bad situation.

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Developed World Oil Consumption Per Capita (barrels/year)

U.S. (left) Germany (right) Japan (right) UK (right)

Sources: Bloomberg, Connolly Insight

Non-OPEC Supply Non-OPEC output excluding shale is another key parameter that the Saudis must take into account when setting their production strategy. Unlike shale production, these conventional projects involve high capital costs and long timeframes. Because of these factors, the mega-projects embarked upon 5-10 years ago will not be affected by near-term price considerations. Chart 10 below shows EIA projections for output growth in the U.S. Gulf of Mexico for 2017. We can see that production will grow both due to new production coming online and upgrades to projects initially brought online prior to 2016. Table A below shows the global pipeline of projects expected to come online in 2017. A significant amount of market commentary has focused on capital expenditure cuts by private and state-owned oil producers. These cuts to mega-project funding may have a major effect on global supply in 5-10 years, but that is not a consideration that will factor into Saudi production decisions now. Any cuts to Saudi production in the present will simply clear space in the market for large-scale projects that cannot be stopped. Indeed, Russia alone has five new fields launching in the fourth quarter of this year that will boost production in 2017 by over 500,000 barrels.

2 The nuclear phase-outs planned by Germany and Japan will not change this trend because Germany has never directly burned crude so it

lacks the facilities to do so and Japan has been replacing both nuclear and oil-fed electrical plants with natural gas-fed plants.

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Source: EIA

Non-OPEC Projects Launching in 2017 (000s bbl/d)

Source: Fattouh (2016)

In the paragraph above we emphasized that cuts in capital expenditure will not necessarily lead to major shortfalls in supply from 2020 on. That view is definitely out of step with the accepted wisdom on Wall Street, but it must be said that Wall Street loves a dramatic story that will help drive deal flow. Large international oil companies (“IOCs”) and the investment banks that help them raise capital naturally favor the story that investors should be willing to fund long-term projects because exploration budgets have been cut across the industry. Investors should take note of the pattern of interests in this story.

We believe the supply-constraint story is likely overdone for two reasons. First, the expensive mega-projects were approved in the mid-2000s when the going storyline was that the world was running out of oil and that it would take bold projects in inhospitable environments to generate enough supply. That view seemed to be confirmed when oil prices rebounded to over $100 in early 2011. No doubt, there are few companies – private or state-owned – with the technical expertise and capital budget to execute these projects of this type. However, spending cuts on large-scale projects are completely justified in a market with an ample supply of projects with short time-cycles and low upfront capital costs, such as shale production.

Exploration activity is much less difficult and expensive for shale plays than conventional plays. Even after a conventional play has been identified, up to 30% of the holes drilled can come up dry. It takes a very specific set of geological conditions to make a conventional well economic. In contrast, shale basins cover huge areas. Once a play is discovered the exploration process is more an exercise in fine-tuning the drilling strategy than in discovering economic places to drill. Cutting shale-exploration expenditures now does not mean much for shale production in 2020.

Second, low oil prices are much more of a problem for oil companies with costs in dollars than those with costs in their local currency. Chart 11 below shows that the price of Brent crude has declined significantly more in dollars than it has in rubles. The result of the favorable (in this respect) currency movement is seen in Chart 12 below. Russian oil companies have not followed the IOCs in making drastic cuts to their exploration budgets. The currencies of most other major oil-producing countries have experienced similar declines. The Saudis have not, but we expect their hand to be forced in 12 months or so after the

10 A

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realization that there is likely to be a long period of low prices is fully absorbed by market participants and OPEC policymakers.

Source: EIA Source: EIA

Shale Elasticity The final factor Saudi policymakers must consider is the likelihood that cuts to production will spur a rebound in shale production. Fattouh (October 2015) introduces an innovative game theory method for analyzing Saudi Arabia’s strategy options. There are two potential game frameworks. In Game 1 the supply of shale is elastic on the upside so that shale drillers are able to increase production in response to even to small changes in the market price. In Game 2 drilling activity is inelastic and OPEC members are able to harvest gains from a cut to production. Table B below shows the potential outcomes for the two games based on whether the Saudis cut unilaterally or in concert with other OPEC members. Fattouh shows the payoff structure in the boxes: Saudi payoff, other-OPEC payoff. Game 1 is a classic prisoner’s dilemma game where both sides cannot collude so neither is willing to cut. In contrast, in Game 2 it benefits the Saudis to cut regardless of what the rest of OPEC does.

As Fattouh points out, the problem for the Saudis is that have no way of knowing ex ante which game they are in. He concludes that, prudence dictates playing as if shale production is highly elastic until enough evidence has been gathered to make a definite call.

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Saudi Game Theory Choices

Elastic Shale Supply Inelastic Shale Supply

Other-OPEC

Cut

Other OPEC

no cut

Other-OPEC

Cut

Other OPEC

no cut

Saudi cut -C, -C -A,0 Saudi cut A, A C, B

Saudi no

cut0, -A 0,0

Saudi no

cutB, C 0,0

Payout Structure

C = Some revenue gain

B = Moderate gain due to market share increase

A = All players cut, no substitution

A > B > C

-A = Worst loss, revenue and market share loss

Source: Fattouh (2016)

Hard data on the elasticity of U.S. shale production on the upside is limited, but early indications are that the industry has bounced back quickly from the price crash. Chart 13 below shows that the rebound in the number of active rigs took six months after prices bottomed in February 2016, which almost exactly matches the lag period after prices topped in June 2014. Of course, the ramp-up in the number of rigs is relatively small in comparison to the drop so it remains to be seen how quickly the industry could reach the peak of just under 1,400 rigs in operation. However, we believe that a ramp-up to such a large number of rigs in the short-run is not necessary to fill any production cut made by the Saudis. Chart 14 below shows that many of the wells drilled in 2015 went into inventory. We can see in the chart that the inventory of uncompleted wells started falling as soon as prices (temporarily) bottomed in February. With evidence mounting that shale production is as elastic – or nearly so – on the upside as it is on the downside, it greatly benefits the Saudis to stick with the optimal strategy for Game 1.

More information should become available after shale producers begin reporting Q3 results next week, at which point we will follow-up with another note.

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HORZ. VERT. 3m Future (right)Sources: Baker Hughes, Bloomberg, Connolly Insight

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Number of Drilled Uncompleted wells. vs. Oil Price

Drilled Uncompleted Wells WTI 3rd Month Futures (inverted, right)

Sources: Bloomberg, Connolly Insight

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Conclusion: Consequences of Making the Wrong Call Are Too Grave to Risk a Cut Charts 15 and 16 below show that the consequences of making the wrong call on whether to cut or not are extremely severe. The Saudi decision to cut production in in the early 1980s in a futile effort to maintain an unsustainably high price resulted in a loss of revenues and market share. Indeed, it took twenty years for export volumes to reach the level seen in 1980 and market share never recovered. As a result, prudence dictates that Saudi production strategy remains one of maintaining a high level of production in order to maximize revenues via volume rather than cutting production in a futile attempt to pull the supply curve back far enough to move the intersection between supply and demand onto the steep portion of the supply curve. We can come to this conclusion because the four factors that make a “market share” strategy optimal all point in the same direction: the outlook for demand growth is weak, OPEC cohesiveness is low, non-OPEC production in 2017 will continue to grow and U.S. shale production appears to be elastic to the upside.

The historically-abnormal black hole of power created by ISIS3 in Syria will draw the region’s major powers – and potentially some of the Great Powers – into increasingly intense conflict. We expect that prices will be very low until conflict – or fears of an imminent conflict – drive a dramatic spike in oil prices. We would summarize our view of price action as low, low, low and then very high.

OPEC Oil Exports 1965-2009 (mb/d)

Source: Gately (2011)

Oil Exports as % of Non-OPEC Consumption (1965 - 2009

Source: Gately (2011)

3 See our notes “Obama, Putin and the Coalition of the 12

th Imam” and “Saudi Arabia: Sunni or Arab?” of 9 October 2015 and 23 December

2015, respectively.

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References Behar, Alberto & Ritz, Robert, 2016. "An Analysis of OPEC’s Strategic Actions, US Shale Growth and the 2014 Oil Price Crash," IMF Working Papers 16/131, International Monetary Fund.

Fattouh, B. (2015, April). The Image of GCC Oil Policy in the Western Media, Oxford Energy Comment, Oxford: Oxford Institute for Energy Studies.

Fattouh, B. (2015, June). Saudi Arabia Oil Policy: More than Meets the Eye?, Oxford Energy Comment, Oxford: Oxford Institute for Energy Studies.

Fattouh, B. and et. al. (2015, October). The Dynamics of the Revenue Maximization-Market Share Trade-Off: Saudi Arabia’s Oil Policy in the 2014-2015 Price Fall, Oxford Energy Comment, Oxford: Oxford Institute for Energy Studies.

Gately, Dermot. "Strategies for OPEC's Pricing and Output Decisions." The Energy Journal 16, no. 3 (1995): 1-38.

Gately, Dermot, and Hillard G. Huntington. "The Asymmetric Effects of Changes in Price and Income on Energy and Oil Demand." The Energy Journal 23, no. 1 (2002): 19-55.

Gately , Dermot, 2007. "What Oil Export Levels Should We Expect From OPEC?," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2), pages 151-174.

Gately, Dermot, (2004), OPEC's Incentives for Faster Output Growth, The Energy Journal, Volume 25, issue Number 2, p. 75-96.

Gately , Dermot, 2011. "OPEC at 50: Looking Back and Looking Ahead," NYU Department of Economics Papers.

Skinner, R. A Comparative Anatomy of Oil Price Routs: A Review of Four Price Routs between 1985 and 2014 (November 1, 2015). SPP Research Paper No. 8-39.

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