Oil & Gas Management An Analysis of OPEC's Pricing Strategy: Has Saudi Arabia underestimated the resilience of U.S. shale oil?

The global environment for oil and gas has changed significantly in just the last few years as a new set of market conditions have been created that can be defined by an increase supply in oil. These supply increases have largely come from technological developments that have allowed for new forms of oil to extract such as shale oil which has in turn reduced the dependence on the cartels and Middle Eastern oil (Doshi & Corrigan, 2015). There have also been changes in the demand due to technology development as well. Engines and efficiencies have reduced the total demand for oil per user despite the fact that the number of total oil and gas users have increased rapidly in the developing world.

The oil industry serves as the foundation for virtually the whole economy. New technologies have allowed the extraction of the oil that still remains in the U.S. Offshore drilling and oil reserves that are only accessible by hydraulic fracking represent the two best examples of controversial extraction methods. However, recently Saudi Arabia has decided to maintain production levels to keep the oil prices low as part of a strategic initiative to increase their market share. They believed that the lower prices would result in fewer U.S. competitors in the shale market due to smaller margins. This analysis will look into Saudi Arabia's strategy and the global oil market in general.

Background

Saudi Arabia has been subject to a significant amount of speculation regarding its decisions to reduce the production levels of OPEC since November 2014; by defying the international pressure to reduce production, OPEC has consistently exceeded its official production target of 30 million barrels per day since May 2014 (Agnihotri, 2015). When OPEC made the decision to maintain production levels in November 2014, the country did so in the face of a weak demand in the market. Saudi Arabia, which is the biggest producer in OPEC, produced 10.3 million barrels per day in September this year and has offered discounts to protect its market share in key regions to countries in Asia and India. It was also a move that could have hurt the U.S. shale oil producers since the lower prices in the market by the production levels could have put pressure on these operations by reducing their margins.

The move to keep OPEC's production at the current levels has been largely driven by competition. But at the same time it has also exposed some of the financial problems within the country. Saudi Arabia's revenues have been shrunk -- by an oil price that has more than halved -- yet the kingdom has a higher pain threshold than everybody else and it will continue with its long-term plan to undermine rivals and secure its market share (Raval & Kerr, 2015). But it is also considered a gamble that could last years, affecting the kingdom's economy far more than anticipated. The kingdom is starting to burn through the reserves that it uses for social spending and maintaining the economy.

Figure 1 - Saudi Revenues (Raval & Kerr, 2015)

OPEC's Strategy

In the face of falling global oil demand, it was largely at the behest of Saudi Arabia, who were driven by the desire to regain lost market share. This strategy was a gamble that U.S. shale oil producers could not sustain production levels at much lower prices. This strategy to decimate the U.S. shale industry has, had some mixed results. According to the data from Baker Hughes Inc. dated 20th February, the number of rigs for drilling oil is the smallest in the United States since July 2011; the figure fell by 37 last week to 1,019 as well as 556 were withdrawn from service since 5th December (Taneja, 2015).

"It is having the effect that we would expect, which is a decline in investment and ultimately supply, and somewhat higher demand. We think this change is for good"

Francisco Blanch, Head of Commodities Research at Bank of America

Within OPEC, other producers, principally Iraq and Iran, are determined to continue raising their output even as prices slump (Kemp, 2015).

"We will be raising our oil production at any cost and we have no alternative," Iran's Oil Minister Bijan Zanganeh said in a news story carried on his ministry's website.

There are also signs output growth from shale drillers and other producers outside OPEC is starting to slow, but it is not falling yet. Yet other reports indicate that the Saudi strategy will begin to take its toll on firms that have higher...

Delegates at the Oil and Money conference in London, an annual gathering of senior industry officials, said world oil prices were now too low to support U.S. shale oil output, the biggest addition to world production over the last decade (Reuters, 2015).
However, at the same time, other OPEC producers are also having their own troubles amidst the falling prices. The collapse in oil prices is especially hurting less affluent OPEC members like Algeria, Angola, Ecuador, Nigeria and Venezuela and one reporter stated that OPEC has never been more divided about what to do about strategy (Egan, 2015).

"Venezuela's oil minister warned that oil could plunge to $25 if OPEC doesn't act fast. Algeria has called for a price floor, while Ecuador's oil minister said the only way to balance the market is to cut production. (Egan, 2015)"

While the rich OPEC countries can probably use their reserves and borrow to fund their economy for a couple years, the poorer OPEC countries will have a harder time maintaining their economies.

Increasing Market Share

Saudi Arabia's strategy is intended to create more market share for Middle Eastern Oil in key markets. China has long been the largest and fastest growing market that has a growing demand for oil, however China's economy has begun to slow and show signs of weakness. In this environment India is beginning to emerge as the most important source of future demand. "India is a big customer of ours. We are also committed to ensure supplies that are essential for India. But, (the investment talks with India) hasn't gelled yet. Hopefully these talks will come to a good conclusion," said Saudi Arabia's influential oil minister Ali Al Naimi in an interview with the Economic Times (Agnihotri, 2015). Saudi has been trying to gain acquisitions in India's oil and gas sector for some time now. Low oil prices have been hugely beneficial to India, saving millions of dollars on oil imports, which account for 80% of the country's total crude oil requirement (Agnihotri, 2015).

Figure 2 - Saudi's Exports (Agnihotri, 2015)

Case Study -- Exxon

On the whole, currently the economic environment for U.S. oil producers such as Exxon and related industries is somewhat bleak in the short-term. The fall in oil prices has led companies to experience falling margins and losses and Exxon has not been immune from this trend, even with its massive size. Companies will have to make some tough economic decision in the short-term.

"Exxon Mobil and Chevron on Friday posted their worst quarterly results of the current decade as oil and natural gas prices continued to plunge.

The results of the companies, and those of almost the entire oil patch this week, were disappointing but not all that surprising since the price of oil is now half what it was a year ago." (Krauss, 2015)

Figure 1 - Prices/Production (The Economist, 2015)

Given the tough economic conditions that Exxon is facing, there is little room for growth in the different types of environments in which they currently operate. However, these challenges also present some room for opportunities and synergy between the existing business functions as they deal with the new environments. Exxon will undoubtedly have to become a more lean and nibble company that operates more efficiently. However, there is also opportunity for an industry giant such as Exxon to use its size and find new investment opportunities.

"Stung by the 58% plunge in U.S. oil prices since June 2014, many drillers face stark choices: shut down rigs to conserve capital and wait out the bust, or surrender some independence to a deep-pocketed savior in exchange for a shot at a future windfall. Exxon is expanding at a time when $40-a-barrel crude is crippling more-indebted companies (Carroll, 2015).

Exxon has already been engaged in a massive buyout strategy to further leverage shale oil. For example, after acquiring XTO in 2010 to capture that company's shale expertise, Exxon relied on the traditional corporate-buyout strategy to expand its holdings; one month after closing the XTO deal, Exxon paid $695 million for Haynesville Shale driller Ellora Energy Inc. and the following year, it paid a total of $1.69 billion for Phillips Resources Inc. and TWP Inc., closely held Marcellus Shale explorers (Carroll, 2015). Exxon is also focusing on ramping up its technology so that shale production can be more efficient. For example, if the company can decrease the costs in shale extraction by twenty-five percent or more, many of the investments that…