OPEC's Pricing Strategy and the Resilience of U.S. Shale Oil

Introduction

The global environment for oil and gas has changed significantly in just the last few years as a new set of market conditions has emerged, defined primarily by an increase in the supply of oil. These supply increases have largely come from technological developments that have enabled new forms of oil extraction — such as shale oil — which have in turn reduced dependence on cartels and Middle Eastern oil (Doshi & Corrigan, 2015). Changes in demand driven by technology have also played a role. Improvements in engine efficiency have reduced total oil consumption per user, even as the number of oil and gas users has increased rapidly in the developing world.

The oil industry serves as the foundation for virtually the entire global economy. New technologies have allowed the extraction of oil that was previously inaccessible in the United States. Offshore drilling and reserves accessible only through hydraulic fracturing represent two of the most significant — and controversial — extraction methods. Recently, however, Saudi Arabia decided to maintain production levels to keep oil prices low as part of a strategic initiative to increase its market share. The expectation was that lower prices would eliminate U.S. competitors in the shale market by compressing their margins. This analysis examines Saudi Arabia's strategy and the global oil market more broadly.

Background: Saudi Arabia's Production Decision

Saudi Arabia has been the subject of considerable speculation regarding its decisions around OPEC production levels since November 2014. By defying international pressure to reduce output, 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, it did so in the face of weak market demand. Saudi Arabia, the largest producer within OPEC, produced 10.3 million barrels per day in September 2015 and offered price discounts to protect its market share in key regions, particularly in Asia and India. This was also a move calculated to hurt U.S. shale oil producers, since the lower prices resulting from sustained production levels could squeeze those operations by reducing their margins.

The decision to keep OPEC's production at existing levels has been largely driven by competition, but it has simultaneously exposed significant financial vulnerabilities within Saudi Arabia itself. The kingdom's revenues were severely reduced — by an oil price that more than halved — yet Saudi Arabia has a higher pain threshold than most other producers and has continued with its long-term plan to undermine rivals and secure market share (Raval & Kerr, 2015). Nonetheless, it is widely regarded as a gamble that could last years and affect the kingdom's economy far more than anticipated. Saudi Arabia has already begun drawing down the reserves it uses for social spending and economic maintenance.

OPEC's Strategy and Its Mixed Results

In the face of falling global oil demand, OPEC's strategy was driven largely at the behest of Saudi Arabia, motivated by a desire to regain lost market share. The strategy was a calculated bet that U.S. shale oil producers could not sustain production levels at much lower prices. Its results, however, have been mixed. According to data from Baker Hughes Inc. dated February 20, 2015, the number of oil drilling rigs in the United States fell to its lowest level since July 2011 — dropping by 37 in a single week to 1,019, with 556 rigs withdrawn from service since December 5, 2014 (Taneja, 2015).

Francisco Blanch, Head of Commodities Research at Bank of America, commented: "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."

Within OPEC, other producers — principally Iraq and Iran — were determined to continue raising output even as prices slumped (Kemp, 2015). Iran's Oil Minister Bijan Zanganeh stated: "We will be raising our oil production at any cost and we have no alternative."

There were also signs that output growth from shale drillers and other non-OPEC producers was beginning to slow, though it had not yet reversed. Other reports indicated that the Saudi strategy would begin to take its toll on firms with higher extraction costs, such as shale producers. Delegates at the Oil and Money conference in London — an annual gathering of senior industry officials — said world oil prices were then too low to support U.S. shale oil output, which had been the biggest addition to world production over the previous decade (Reuters, 2015).

At the same time, other OPEC producers were experiencing their own difficulties amid falling prices. The collapse in oil prices was especially damaging to less affluent OPEC members such as Algeria, Angola, Ecuador, Nigeria, and Venezuela. One analyst observed that OPEC had never been more divided about its strategic direction (Egan, 2015). Venezuela's oil minister warned that oil could plunge to $25 per barrel if OPEC did not act quickly. Algeria called for a price floor, while Ecuador's oil minister argued that the only way to balance the market was to cut production (Egan, 2015). While the wealthier OPEC countries could likely use reserves and borrowing to fund their economies for a year or two, the poorer member states faced far greater difficulty sustaining their economic foundations.

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