In the game of overproducing oil while its price is nearing rock-bottom, there are no winners. But in a prolonged low-price environment for crude oil where everyone loses out financially, sometimes you have to feel the heat before you reap the rewards.
Saudi Arabia made the decision last November to increase oil production and squeeze out high-cost competitors, primarily in the U.S. shale plays, but also to inflict pain on serious rivals such as Russia and Iran. While the latter goal has been largely successful, particularly in adding to Russia’s economic misery, U.S. producers have proven to be doggedly determined to continue producing until it becomes financially impossible.
The result has been a prolonged game of economic chicken, as producers race to see who can last longest while the black gold is at its lowest point since 2009.
But despite its financial woes, Saudi Arabia isn’t likely to lose in the long-term, and here’s why.
If You’re Buying Oil Stocks Now, You’ll Hate Yourself Later
Much has been made of the recent Saudi decision to cut budgetary expenses by approximately 10%, as government spending is forecasted to outpace gross domestic product (GDP) by 20%. (Source: Financial Times, last accessed August 27, 2015.) Criticism of the Saudi strategy has pointed at the negative effects on the country’s economy, but ignores the policy signals this sends out.
The OPEC giant will be feeling a projected $97.0 billion budget deficit in 2015. (Source: Businessweek, last accessed August 27, 2015.) This is an astronomical number until you look at the country’s financial position and the scope of its economic strategy.
Saudi Arabia still has a $668 billion sovereign wealth fund, despite burning through an estimated $68.0 billion since the plunge in oil prices started. (Source: Bloomberg, last accessed August 27, 2015.) The Kingdom is far better positioned to weather the storm than its rivals, both in OPEC and outside it.
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The Saudis are not going to cut production at this moment, because this is the point at which their competitors are beginning to feel real financial pain. Don’t believe me? The data is more alarming than most media would have you believe.
Following several years of skyrocketing growth, American oil production has essentially peaked. And according to the most recent reliable data, it has now finally begun to decline. (Source: EIA, last accessed August 27, 2015.) March crude oil output stood at 9.69 million barrels per day (bpd), falling to 9.51 million barrels in May. Considering that oil demand is stagnating, there is no reason to expect that number has increased since then.
It’s a fact that U.S. oil production will continue to drop if the Saudis continue this strategy of retaining market share at all costs. Many small and medium-sized U.S. energy companies are stretched to their absolute financial limit, as bankruptcies and defaults are spreading, and there’s more carnage to come. Indeed, the average net debt to earnings ratio in the U.S. oil sector is the highest in two decades. (Source: Bloomberg, last accessed August 27, 2015.)
And remember, debts can only be kicked down the road so much before you have to face reality.
The accumulation in debt in the energy sector has created a snowball effect according to data compiled by BMI research. (Source: Bloomberg, last accessed August 27, 2015.) The volume of repayments will increase until at least 2020 by an alarming rate, with $85.0 billion owed in 2016 and $129 billion in 2017. More than half a trillion dollars in outstanding bonds and loans will be due for repayment over the next five years, with U.S. producers holding a fifth of that.
Crashing oil prices are reducing the overall value of oil reserves, which diminishes the value of oil companies’ assets and their borrowing power. Broad credit rating downgrades are hitting even the largest oil majors, reducing their ability to raise cheap capital. As revenue streams become dangerously dry and debts mature, many energy companies are now finding themselves in a dangerously exposed position with no way out.
While the largest oil majors are capable of surviving on the strength of their international assets, you can expect the wave of bankruptcies to start increasing by the end of 2015. The trend towards mergers will also pick up speed, as three of the last five financial quarters have exceeded $160 billion in deal volume, higher even than late 1990s levels, when several of the world’s largest oil and gas companies were formed. (Source: Bloomberg, last accessed August 27, 2015.)
The MSCI World Energy Index is showing earnings levels now plunging below those of the 2008 Financial Crisis, as profit margins for even large companies such as Chevron Corporation (NYSE:CVX) and Exxon Mobil Corporation (NYSE:XOM) now at their lowest point since at least 1995. (Source: MSCI, last accessed August 27, 2015.)
It took some time, and swallowing a good deal of pain, but it looks as if Saudi Arabia’s strategy is working.
Continuing down this path allows the Kingdom to achieve its strategic goal of defending market share, while letting crude prices adjust upwards at the expense of rival producers either being ruined or severely hurt. With the oil price forecast looking grim for 2015, the OPEC giant can simply buckle down and wait.
Rather than looking at the Saudi decision to curb its budget this year as a sign of defeat under low-price pressures, the reality is that it’s a signal of their resolve to maintain this strategy for the long-term if necessary. (Source: Oilprice, last accessed August 27, 2015.)
Saudi Arabia does not expect prices to rise anytime soon, and you can expect them not to adjust their market behavior.
This Could Send Oil Prices to $30.00 per Barrel
Don’t be seduced by today’s rally in oil markets. It’s purely psychological, based on favorable U.S. economic data, and isn’t likely to last. Fundamentals are still heavily stacked against crude oil, with global oversupply, growing stockpiles, and stagnant demand all acting as downward price pressure. With fall refinery maintenance season around the corner and ongoing volatility in China, oil prices are likely to slip down and remain in the $30.00s, if not lower.