The end of Saudi Arabia as oil’s central banker

The end of Saudi Arabia as oil’s central banker

Although an agreement among Saudi Arabia, Russia, Qatar and Venezuela is the first of its kind in 15 years, it will not, in itself, be the “magic cure” to low oil prices. It is really the opening move of an energy politics chess game in which the rules for Saudi Arabia have changed.

By agreeing to “freeze” oil output at January 2016 levels, oil producing countries can continue to produce oil at record levels. The agreement therefore is unlikely to clear the oil glut before the end of 2016. Moreover, the agreement is contingent upon Iran’s participation. Prior to the 2012 sanctions on Tehran, Iran was producing about 4.4 million barrels per day. Iranian production in January 2016 stood at about 2.8 million barrels per day or 64 percent of the pre-2012 level. Iran has already stated its goal of raising production to 4 million barrels per day in the next few months.  

Saudi Arabia has displayed some nimble energy diplomacy with this agreement because it has now shifted the responsibility for low oil prices to Iran. Tehran’s 4 million barrels per day target may not be feasible in the timeframe the Iranians have set, and so Iran may come to some compromise by accepting a temporary output level below 4 million barrels.

However, there is a bigger story behind the agreement. Saudi Arabia has revealed that it can no longer unequivocally play the role of “central banker” of oil prices. U.S. shale oil production has permanently changed the rules of the game. The oil price war has failed to put U.S. shale out of business. And, it will not succeed because large energy companies, hedge funds, and private equity groups will buy distressed U.S. shale producers. U.S. shale is not like offshore oil production, it only takes about $10 million and 20 days to drill for shale. For this reason, U.S. shale has been more resilient than many analysts previously thought. For example, U.S. shale surprised many observers by surviving when oil dropped to $70.

The bottom line is that U.S. shale is now the monitor of oil prices. When the oil price pushes past $50, U.S. shale operators will start producing again (although some may wait for a price crossing $60). Thus, if the new agreement succeeds in raising oil prices to $50, then shale production will kick in again halting the price rise.

If U.S. shale production becomes more efficient, Saudi Arabia’s cost production advantage will shrink. Other nations already do not enjoy Saudi Arabia’s cost advantage over U.S. shale production. Increasing efficiency will further tilt the game in U.S. shale’s favor. By abandoning its oil price war with U.S. shale through seeking and output freeze with other major producers, Saudi Arabia has demonstrated that it has lost its crown as oil’s king. 

*Dr. Michael Tanchum is a non-resident senior fellow at the Global Energy Center and the Eurasian Energy Futures Initiative at the Atlantic Council.