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Oil prices are once again in news as weak demand from China accelerated the fall after Iran joined the already over-supply oil market. In a recent report, Bank of America says the much-feared double dip in the oil market is upon us. Double dip signals that prices are heading downwards and might touch the previous low and are likely to stay there for some time.
Goldman Sachs in a client note called for oil prices to fall to $45 a barrel by October. The note mentions that the global crude market is currently oversupplied by two million barrels a day, up from 1.8 million barrels a day in the first half of the year.
But the present fall in prices is more structural in nature and one that can keep oil prices depressed for a long time. What is important in this fall in prices is how the industry has changed in the last 18 months since oil prices started to decline below the $100 per barrel mark.
In order to understand the changing dynamics in the industry, we will have to go back to the period when oil prices were artificially kept high by controlling supply, mainly by the Organization of Petroleum Exporting Countries (OPEC).
Higher oil prices led to a search of an alternative source of oil. This gave birth to the development of shale gas from newly developed technology, mainly in the US. Such was the growth in the industry that USA, from being an importer of oil, turned into a net exporter in less than a decade. High oil prices gave the shale oil industry the incentive to innovate and start commercial production.
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But the initial technology was developed by working under the luxury of high prices. Most of the shale gas companies had developed the technology with a cost component of $60 per barrel.
This was the assumption under which Saudi Arabia called the bluff of refusing to cut production. They expected that if prices fall, shale oil wells will shut down and the companies will have to go in for bankruptcy.
The plan did work initially. Oil companies reported drop in profits. Further, wells producing shale gas dropped sharply. Number of wells producing shale oil came down from 1,608 in October 2014 to a low of 659 in June 2015. Oil companies shelved large projects, deferring $200 billion of investments through 46 large projects.
But despite lesser wells running, oil production in the US touched a 43-year-old high of 9.6 million barrel per day. This was something very few in the industry including Saudi’s had envisaged. Shale gas producers used the opportunity to cut down cost, renegotiate their terms with service providers and increased production as a way of generating more dollars.
John Hess of Hess Corporation a shale gas producing company pointed out that they have already driven down drilling cost by 50 per cent and see another 30 per cent ahead. Further, technological advancement in drilling led to more oil being produced from the same well.
According to a HIS Energy research, shale producers have lowered their costs to such an extent that their average break-even price for a barrel of US crude is now in the upper $40s, down from $60. This is where the Saudis miscalculated and have now fallen in their own trap.
‘Saudi Arabia may go broke before the US oil industry buckles’ points out columnist Ambrose Evans-Pritchard in The Telegraph. If the oil futures market is correct, Saudi Arabia will start running into trouble within two years. It will be in existential crisis by the end of the decade, writes Ambrose.
Forbes has reported, quoting unconfirmed sources that the Saudi’s are seeking $27 billion in debt via issuance of bonds. The country is losing $12 billion per month after oil prices have fallen. Oil constitutes 90 per cent of Saudi’s revenue. The country needs a price of $106 per barrel to balance its budget.
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IMF had pointed out that the budget deficit of Saudi Arabia will touch 20 per cent in the present year. Reducing the country’s outlook to "negative" S&P had said "We view Saudi Arabia's economy as undiversified and vulnerable to a steep and sustained decline in oil prices."
Both the OPEC nations and the shale oil producers in the US are pumping more oil to boost their revenues from declining oil prices. In doing, so they are earning the same amount of money on account of lower prices but their actions are keeping oil prices low. Further, newer shale oil technology will ensure that as oil prices increase other wells which have been closed down will also add to the supply.
For India, nothing could have been better than this fight for oil supremacy as it keeps its oil imports bill low and deficits under check. The ways things are in the oil market, government will not have to worry about oil prices for some time now.
