Production in Saudi Arabia, Iraq and Venezuela is at or near the highest level in a year. Russia, now the biggest crude producer in the world, increased its output by 1.3 percent year-on-year in January through July, and is pumping 10.6 million barrels a day. U.S. production has dipped slightly in recent weeks, to 9.3 million barrels a day from the June peak of 9.6 million, but it’s still substantially higher than a year ago, when prices were more than twice as high.
The simplest explanation for this phenomenon is that the producers need the cash; the lower the price, the more they need to sell to maintain revenue. Among the trio of top oil producers — Russia, Saudi Arabia and the U.S. — this need-for-cash argument works best for Russia. Last year, as crude prices began to tank, it quickly floated its currency. Since then, the ruble has devalued in lockstep with oil, so that every extra barrel sold produces the same revenue in rubles, which is the currency of the government’s budget. As a result, Russia has no reason to cut production, even if it probably will suffer a future decline in output, because its major oil companies have sharply reduced investment.
The Saudis haven’t unpegged the riyal from the U.S. dollar, so selling more oil at lower prices doesn’t make much economic sense for them. They are convinced, however, that it makes strategic sense. Although the first onslaught on the U.S. shale producers has proved ineffective, they are determined to press on. “It is becoming apparent that non-OPEC producers are not as responsive to low oil prices as had been thought, at least in the short-run,” the Saudi central bank said in its latest stability report, adding:
The main impact of the current lower prices has been to cut back on developmental drilling of new oil wells, rather than slowing the flow of oil from existing wells. Thus, the impact of lower prices today is expected to be on future oil production, rather than current production. This requires more patience on OPEC oil producers and a willingness to maintain steady production until the demand catches up with the current supply levels.
The risk for the Saudis is that they have misjudged U.S. shale. Last year, investment banks estimated break-even costs for major U.S. shale plays at more than $60 a barrel, but a recent Bloomberg Industries analysis suggests this was inaccurate. It shows, for example, that in North Dakota’s McKenzie County, part of the Bakken shale play, the break-even price is about $29. Neighboring counties only need a slightly higher price to break even. Analysts had underestimated the ability of tight oil producers to cut costs and apply new technologies to increase output per rig. The U.S. Energy Information Administration says production per rig has significantly increased in the past year, for all of the country’s shale areas.
That, however, was only to be expected in a price war. The Saudis couldn’t have hoped that their U.S. rivals would just roll over and won’t be deterred by this show of resilience. Besides, they have reason to believe that new technology and cost-cutting weren’t the only reasons U.S. shale hasn’t buckled.
In July, Bloomberg News reported that at least 15 percent of the first-quarter revenue for 30 of 62 oil and gas companies in the Bloomberg Intelligence North America Exploration and Production Index came from hedges, derivative contracts that allow producers to lock in prices. In effect, the hedges allow companies to go on receiving a higher than market price for their output. The share of revenue accounted for by hedges is likely to have increased in the following two quarters, as crude became cheaper.
The hedges are a big part of the explanation why U.S. companies have maintained production levels, but most will run out by the end of this year. It’s unlikely they will be renewed, because it’s too expensive in the current market to fix future prices at up to $90 a barrel, the kind of money frackers are often still paid now thanks to derivatives.