Equity Finance Betting Against Saudi Arabia

Earlier this year, equity finance players like Blackstone Group LP said they would be out in force cherry picking for cheap oil and gas assets. The theory was simple. As everyone with any experience in oil cycling can tell you, it is too hard to pick “the bottom.” Equity finance players know that and said they liked the market at $50 because the odds were that prices would recover above that in the investment time window for their holdings of two to five years. No point waiting for the full brunt of a sell off. Get the best assets now while you can. But ironically, everyone agreed, including the companies who might have needed to sell assets. And so, no massive asset sell off is taking place yet. Companies are holding tight. Moreover, the U.S. industry is sitting on a massive inventory of thousands of uncompleted wells awaiting a WTI price recovery above $60. And, companies that can are also looking at re-fracking existing wells where incremental production might be had at a lower development cost.

Analysts disagree on what the falling rig count versus this continuation of available finance will mean for the rest of the year. Some, like Citi which is assuming large gains in recovery rates through technical improvements in productivity, still expect U.S. production to end the year up by 500,000 b/d or more. Others, using more conservative methodology closer to the U.S. Department of Energy modeling, expect U.S. production to be down by 2016 by 1 million b/d, if prices remain in the $50s. Non-OPEC production in March still showed gains overall.

For Saudi Arabia, it is creating a quandary. Is $50 too high to achieve its goals?

Geopolitically, $50 has been effective but not definitive. Vladimir Putin’s inner circle seems shakier but Russia has not altered its policies towards Syria and peace talks are not progressing. Iran has come to the bargaining table on its nuclear program but the deal that is likely to be struck is not one that fully satisfies Saudi Arabia’s security concerns. Iran is still expanding its regional power through proxy wars, putting the Saudis even more on the defensive, especially along the long Saudi border with Yemen.  The escalation in the Yemen war contributed to a significant rise in oil prices, bring Brent back over $60 and West Texas Intermediate up to $57 from lows in the $40s. Oil movements through the Suez Canal have to traverse the Bab El-Mandeb chokepoint which borders Yemen and Djibouti. Roughly 3 to 4 million b/d of oil travels that route. While it is possible for shippers to bypass the Suez Canal, escalation of the Yemen conflict unnerved oil markets for several reasons beyond fears of physical disruptions to tanker movements. Firstly, it showed that the conflict between Saudi Arabia and Iran continues to spread across the region, with potentially negative consequences for other regional production. Secondly, it showed that Russia and Iran are willing to use military force to alter market psychology and counter Saudi efforts to lower oil prices. As ISIS expands to the southern gulf and West Africa, conflict in oil producing areas could widen.

During the Iraq-Iran war, Saudi Arabia and its Gulf neighbors stayed the course of maintaining lower oil prices to hinder Iran’s war effort throughout the 8 year struggle. Equity finance players and oil traders alike are betting the Saudis will abandon its strategy rather than escalate it and rumors of a Saudi-Russian deal for June continue to circulate even though they make no sense. Betting on a reversal of the Saudi price war strategy might prove a risky if the U.S. and Europe are able to complete a deal with Tehran on the nuclear issue in June. Saudi Arabia may have no choice but to try to contain Iran’s regional expansion through even lower oil prices, since a military approach is proving difficult at best. The P5+ nuclear deal would give Iran access to more funds and Riyadh’s only way of preventing that will be to refuse to cede market share to Iran’s National Iranian Oil Company (NIOC). Analysts who forecast that it will take Iran over a year to repair its oil fields miss a key point: Iran has upwards of 60 million barrels of oil (or more) in floating storage.  Tehran is pressing for the right to sell that oil as soon as the deal is signed.

Geopolitics aside, the pent up oil investment war chest held by equity financiers may also mean Saudi Arabia will need to reassess whether $50 to $60 is “the number” for forcing non-OPEC competitors out of the market. If current prices are not low enough to scare away investors, then as companies make a serious effort to cut costs, even lower drilling budgets will stretch further. The United Kingdom and Norway are already responding to pressures by lowering royalty taxes. Other non-OPEC countries may follow suit.

Non-OPEC output from Canada, the United States, Russia and Argentina have started to sputter of late but the small losses are overshadowed by a giant increase in production from OPEC producers including Saudi Arabia itself, Angola and Iraq. As the possibility of extra Iranian barrels approaches, Riyadh will have to decide if $50 oil is simply too high to achieve its goals. But getting prices lower than that may take some fancy footwork as traders see an escalating war across the Middle East as an excuse to remain long.