Oil: What Are the Saudis Up To?

The biggest energy story of the last decade obviously has been the U.S. oil boom, which defied everyone’s predictions—including the oil companies themselves. You simply can’t find a single forecast from 10 years ago that called for the kind of increase in domestic oil production that we’ve seen in just the last four years.

When the price of oil started rising more than a decade ago—topping $60 a barrel at the time—I recall talking with oil company executives and asking why the higher price wasn’t stimulating more exploration and production both here and abroad. The answer was that the industry didn’t trust that the higher price level would last, and that they wouldn’t look at any projects that cost more than about $40 to $45 a barrel to produce. This looked prescient in 2008, when the price of oil did indeed crash below $40 a barrel along with the crash of the global economy.

But rapidly improving production technology (more precise directional drilling as well as fracking) reduced the production cost of previously marginal fields along with the higher durable plateau of oil prices—between $90 and $110 a barrel for a while now (with occasional spikes to near $150)—changed a lot of minds, such that the production companies will now develop fields with a cost-per-barrel as high as $80, still profitable at recent market prices.

Right now oil prices are slowly sliding, hitting a four-year low today below $90, the combination of rising U.S. production, a slowing global economy, and sagging demand in China. And one more thing: the Saudis, the hinge producer of OPEC, haven’t so far cut production to keep the price propped up as they have in the past. To the contrary, according to Walter Russell Mead the Saudis are offering price discounts to preserve their market share.

But could there be a more sinister reason? If oil prices keep falling, it will not only hurt some of the Saudis’ OPEC partners who have high production costs and big requirements for oil revenues to fund their governments (especially Venezuela and Iran), but it could put the squeeze on American producers, perhaps even leading to a domestic oil crash as happened in Texas and Oklahoma in the mid-1980s. “Our friends, the Saudis” wouldn’t do that, would they?

Energy analyst Christopher Helman wrote today at Forbes:

Oil company analysts at Credit Suisse ran a scenario last month looking at the effect of sustained $70 oil on American drillers. They found that “upstream growth momentum would quickly deflate,” with 11% fewer wells completed.

It may be doubted that the Saudis could pull this off, for the simple reason that they probably can’t sustain a dramatically lower oil price for very long without flooding the market, which would make little sense in the long term. And the U.S. oil industry is much more nimble than it was in the 1980s, suggesting that any price-caused slump in the industry would likely be short lived. But it is a thing to think about as you enjoy lower gasoline prices at the pump. I wouldn’t be surprised to see a major swoon in oil prices some time over the next year or two.