PRE 2016 PRESIDENTIAL ELECTION

The recent decision by OPEC (specifically Saudi Arabia) to maintain its crude oil output level was originally interpreted as strictly a move to limit the growth of tertiary recovery in the United States and to maintain or actually increase the Saudi’s market share. To a great extent future planned projects have been reduced in the United States and the rest of the oil producing countries, but much of this reduction has to be credited to the substantial slowdown of global economic growth (especially in China). Note that China’s growth has slowed dramatically which has drained over $220 Billion from its foreign exchange reserves in Q3 of 2015 dropping this reserve to its July 2013 level. The price of oil tends to be extremely volatile and when demand start to catch up with supply, the price will escalate quickly. The present supply/demand imbalance, however, may last through much of 2016 and perhaps well in 2017 unless global economic growth increases at a greater pace than projected (other factors will be discussed later). The cost of fracking has come down radically and with the lesser efficient players abandoning their more costly projects, going out of business or being bought out by more efficient less leveraged players. The cost of many of these fracking projects are now substantially below the $80 per barrel level typically viewed as the breakeven point. The U.S. rig count, however, is back down to its 2009 low and when demand does start to catch up with supply there may not be enough rigs in place in the US to allow for a rapid ramp up of production to meet demand. Under that scenario the price of oil could escalate precipitously if and when world demand exceeds supply. It is equally likely that the overall efficiency of fracking will continue to increase as the less efficient fracking projects are abandoned and technology improves, and that the average cost of crude oil derived from fracking will drop close to if not at or below current price levels (both WTI and Brent).

Another aspect of the Saudi decision to maintain oil output levels in the face of weakening demand relates to the geopolitical turmoil that is devastating the Middle East. The colossal policy blunders of the Obama Administration that have affected the balance of power in Iraq, Syria, Libya and the Middle East as a whole has created a scenario where Saudi Arabia has been forced to take actions that bolster it’s position in the Middle East. Remember that Saudi Arabia’s only significant economic weapons are oil and the sovereign wealth derived from oil. At the present time, thanks to the poorly crafted nuclear agreement between Iran and the West (primarily the US), Iran will have sanctions lifted which will release approximately $150 billion in assets to the Mullahs along with the unrestricted ability to sell oil on the world market (which will add about 1 million barrels a day to world output). Russia and Iran have been allies regarding Middle East affairs and both support the Assad regime in Syria. The Obama administration’s handling of Iraq, Isis and the nuclear agreement with Iran has shifted a significant amount of power from the Sunni rulers of Saudi Arabia to the Shiite Mullahs in Iran, their Russian allies, Syria and numerous Iranian surrogates in the Middle East.

The precipitous drop in the price of oil and gas has severely hurt the Russian economy and will dampen the benefit Iran will have when it will be able to sell oil on the world market. I believe that these two factors may among the primary outcomes that Saudi Arabia targeted when they decided to maintain oil production levels in the face of shrinking global demand. Towards the end of the cold war (mid to late 1970’s) I vocalized the position that the massively inefficient Russian economy would not be able to sustain a ramped up military arms race and that making a push in this nature would render them vulnerable to financial collapse. I made the humorous remark that the weakness in their capital structure meant that getting into a spending spree would be equivalent to going to a game of marbles with no marbles. We all know what events culminated from that situation. I believe that the Saudis learned from this and decided it is in their best interest to break the Russian economy if possible or at least weaken it to a point that it would have to modify its activities in the Middle East that are counter to the interests of Saudi Arabia.

The cost of this action to Saudi Arabia has been substantial, but it doesn’t appear that they have any plans to back off in the immediate future. As of August 2015 their foreign exchange reserves have dropped by over $650 Billion since its high in Q1 of 2014 dropping it to its lowest level since Q1 of 2013. Their foreign exchange reserves are still in excess of $3 Trillion (2016), but at the present price of oil they are burning through those reserves at an unsustainable pace. It should be noted that even though their cost of production is extremely low, oil revenues must sustain the entire infrastructure and other needs of the kingdom. For the American producers only the cost of production is relevant.

Once the dust settles and the global oil market begins to recover, unless prices rise substantially in the near future, many of the highly leveraged less efficient producers in the U.S. will be bought out by the large multinationals and the more efficient less leveraged mid size producers. Fortunately, some of the more highly leveraged producers have hedged their revenue stream which should sustain them through 2016. All bets are off, however, if the price of oil remains depressed well into 2017. The entities that survive will be profitable at a significantly lower cost per barrel and American production will continue to be a major player in the global oil market. As a final remark, Saudi Arabia’s drive to continue its present oil production policy will soften over time as US drilling and production moderates and other oil producing countries become more compliant with Saudi objectives. I expect that Russia in the near future will make overtures to the Saudis which will evolve into a more stable market as long as Saudi Arabia believes that its geopolitical posture is secure and that the Middle East will not be dominated by a Russian/Iranian alliance. The only reason that the Russian/Iran alliance has not already agreed to whatever demands that the Saudis may have is that the totally unadvisable Iranian nuclear deal espoused by the Obama Administration has generated the expectation of a massive influx of capital into the Iranian coffers, much of which will be utilized to purchase offensive weapons from Russia. To a great extent, Middle East stability will be influenced by the outcome of the next American presidential election. . Recently, Saudi Arabia has suggested that they are considering establishing an IPO relating to their oil production. Obviously, they will seek to stabilize the oil market before undertaking that action. As discussed above the burden of maintaining production levels in the face of lagging demand has had a massive negative impact on the Saudi Sovereign Fund and a stable oil market leading into any proposed IPO is an obvious necessity for that IPO to be of significant benefit to the Saudis.