​Press Room

Sharing the spoils


Matthew Chapman
Jun 02, 2016
How the Saudi led strategy to take back the oil market has played out and how oil rich nations are adapting or failing to adapt.

With oil prices having recently recovered some 80% from a 12 year low of under $28 in late January this year, we can now begin to see the success of the Saudi led strategy to squeeze out competitors for market share by indirectly reducing global oversupply conditions and moving the market closer to rebalancing the demand/supply mismatch. The policy of abandoning production limits, which began over two years ago in response to a surge in US shale production, is beginning to work with US production falling for 11 straight weeks this year and now expected to be 8.5% lower than last year, according to the Energy Information Administration (EIA).

Looking back over the past year and a half to the November 2014 OPEC meeting in Vienna, where it was expected that OPEC would initiate production cuts to arrest the accelerating decline in oil prices, the old adage of no pain no gain lays no exception to the situation which subsequently played out. Post the announcement of a refusal to cut output ceilings, oil prices collapsed from over $70 to $45 a barrel in the space of two months, and then, through a period of turbulent volatility, a further 40% over the next year to the economically unsustainable levels witnessed earlier this year. The intended effect was to squeeze U.S. shale producers who had taken on massive amounts of debt in favourable interest rate environments, with the blinkered expectation of a sustained environment of inflated oil prices. To contextualise the collapses, some 77 North American oil and gas producers have filed for bankruptcy in the short space of 17 months from the beginning of 2015, according to Houston law firm Haynes & Boone LLP. The combined debt owed by these entities amounts to a colossal $52bn which is roughly equal to the combined market capitalization of global heavyweights Richemont and Steinhoff International.

With treasury yields at historically low levels, the shale boom was funded through the junk debt market as investors rummaged for returns in more risky assets. The risk-on trade failed to pay off though as shale producers lost the ability to service this high yield debt which resulted in U.S. high-yield energy debt losing some 24% of its value last year. Not exactly what you’d expect from an asset class as theoretically safe as bonds. What we did see however, as has become synonymous with U.S. capitalistic behaviour, is the optimized efficiencies of a number of the larger shale producers coming in the form of drastically reduced operating costs and smarter and more efficient drilling techniques in response to lower oil prices. These included everything from renegotiated lease operating expenses to innovative well cost optimization through improving rig logistics. This resulted in a drastic reduction in the breakeven point of production for these companies, thereby, allowing them to remain in the game.

As can be seen from the graph below total (and shale for that matter) US oil production has only just begun to trend downwards, even after a radical drop in the number of active rigs in late 2014. This comes in the form of increased production per rig by the diversified producers with deep enough pockets to adjust their production models to survive longer and also ignite a period of mergers and acquisition consolidation in the U.S. oil and gas industry.

U.S. Oil Production  

(Source: NFB Asset Management & U.S. Energy Information Administration)

Whilst these large companies are accountable to shareholders and thus obliged to adapt to changing market conditions and acclimatize to new price realities, the same cannot be said for all state owned oil companies and their national economies:

  • Russia, alongside international sanctions, experienced rapid deprecation of the rubble and a sovereign credit rating downgrade to junk status.
  • Nigeria has had to cut a $2.7bn annual fuel subsidy and heavily draw from foreign currency reserves, which have already decreased by a third in the last two years.
  • Venezuela, perhaps the worst hit of all oil producing states, is essentially on the brink of economic collapse.*

Countries who have managed to fair better have included the likes of Mexico who, as we mentioned in a previous article on the Mexican peso, have had a long standing policy of utilizing derivative markets to hedge out the risk of adverse oil prices with a floor of $49/bbl secured for 2016.

Saudi Arabia themselves have had to adjust their own policies and strategies in response to the self-inflicted glut in oil supply. Prince Mohammed bin Salman, affectionately known (to those who hold affection towards the contentious, power hungry young monarch-in-waiting) as MbS, has already reduced massive subsidies on gasoline, electricity and water and plans to introduce an unprecedented VAT system and levies on luxury goods and sugary drinks. In a country accustomed to zero income tax and a 2.5% corporate tax for Saudis, any major move to disrupt the status quo is likely to be seen as threatening.

However, rather than a shotgun response to current short term economic pressures, the policy changes and recent rhetoric is part of a long term plan outlined by the prince on April 25th titled the “Vision for the Kingdom of Saudi Arabia.” The aim of this new economic vision is to reduce Saudis reliance on oil and create a situation that makes “investments the source of Saudi government revenue, not oil.” The major proposal is the creation of a $3trn sovereign wealth fund (SWF), which will dwarf the world’s current throne-bearing SWF in fellow oil rich nation Norway at $850bn. Included in the fund will be the state owned oil company Saudi Aramco, 5% of which the prince plans to sell in public markets. To put shame to the local equity comparison made earlier in this article, at $3trn, the Saudi SWF would theoretically be able to purchase Apple; Google; Microsoft; ExxonMobil and Berkshire Hathaway – the five largest public companies in the world – and still have enough change to buy not just one $1 hot dog, but more accurately 780 billion $1 hot dogs (ignoring any bulk discounts).

The fund has plans, through partnerships with global private equity businesses, to diversify its assets up to a 50% holding in overseas markets and thus also create a steady stream of dividends not tied to the price of fossil fuels. Not a bad decision from any long term investor.

This diversification and long term plan to decouple state revenues from oil comes at a time where Saudi Arabia perhaps made its most daring move, as the swing producer in global markets, in terms of its oil weapon warfare strategies. With both the U.S. and Russia gradually capturing market share a drastic plan needed to be taken. By enacting a plan that would flood the world with a glut of oil supply and utilize foreign exchange reserves to balance the budget, the aim was to quickly make it impossible for higher cost producers to remain in the market. However, as shale producers in the U.S. were able to adjust and continue at production levels which would ensure lower for longer oil prices, the plan may well have backfired. Last spring the IMF estimated that Saudi Arabia’s reserves could last them a further five years at depressed oil prices and, without drastic changes in government spending, this may have been reduced to as little as twenty four months.

With oil prices now having recovered to above $50/bbl at the time of writing there may be less pressure within OPEC to initiate production cuts, although with Saudi cooperation in any quota reductions hinging on Iranian inclusion, there is not likely to be a resolute decision at the next OPEC meeting in Vienna on June 2nd.

The future of the oil price is a complex matter of intricate supply shocks and strategies, alongside an unpredictable demand profile with the global economy stalling and arguable Chinese data figures sending mixed signals to the market. What is certain is that the perceived plan to squeeze out shale producers, although not as sudden as may have been expected, is beginning to work. As such, although also placing major pressure on OPEC compatriots, the Saudi plan to regain power as a swing producer is taking shape in its latest push for power in the hugely relevant and fundamental global oil industry. At the end of the day, we are not getting worked up about the spikes and strikes in the Frozen Concentrated Orange Juice (a tradable commodity) industry after all.

*Venezuela

In a country where oil exports make up 95% of the country’s revenue, hyperinflation in the region of 500% this year and a projected 1,600% in 2017 has wiped out the value of the Venezuelan bolivar, which has depreciated over 400% over the last year. The economy contracted 6% last year according to the IMF and is anticipated to shrink by 8% this year. The water and electricity crisis has become so dire that public sector workers have now been ordered to work for only two days a week to save on energy usage, in a sector which accounts for 20% of the workforce. President Maduro in a further (evidently somewhat desperate) attempt to curb electricity usage has asked women to only use a hairdryer on special occasions, saying ‘I always think a woman looks better when she just runs her fingers through her hair and lets it dry naturally. It’s just an idea I have.’ The country has even gone as far to shift its time zone forward to save on power. Perhaps the most sobering statement on the issue was made recently by Andrew Rosati of Bloomberg who, in reference to the country’s need of having to import most of the newly printed notes, coupled with dwindling foreign reserves and the hyperinflationary environment, said “Venezuela, in other words, is now so broke that it may not have enough money to pay for its money.”

What to look at in the ‘oil price’

When quoted the ‘oil price,’ you may in fact be quoted one of a number of indicators. The two most common benchmarks are WTI (West Texas Intermediate) and Brent Crude. WTI is the benchmark for U.S. producers whilst Brent is the EMEA (European; Middle East and Africa) comparable, with over two-thirds of global oil trade being that of Brent. Historically WTI traded at a slight premium to Brent due to the higher quality of the commodity, however, as the Libyan crisis of 2011 reduced Brent supply, alongside logistical issues with transporting large amounts of WTI from the Cushing area in Oklahoma, we have seen a reversal of this relationship which now has Brent trading marginally higher than WTI.

In order to understand the quality differences in the two benchmarks there are two defining measurements – the sweetness of the oil and the API (American Petroleum Institute) gravity index rating. The sweetness benchmark measures the level of sulphur content with a reading of below 0.5% considered sweet, while the inverse can be considered sour. Sour oil comes mostly from Canada; Gulf of Mexico; South America and the Middle East. Sweet oil is found in the central U.S., North Sea of Europe; Africa and Asian Pacific region.

The API reading measures the density to water, or gravity, with ‘light’ oil obtaining a higher reading and being preferable to ‘heavy’ oil. WTI is both lighter and sweeter than Brent crude, hence the historical premium.

Brent Crude (Source: NFB Asset Management & Thomson Reuters Datastream)