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Analysis

Saudi Arabia’s role as ‘swing’ oil producer

by Ben Robinson

Saudi Arabia’s role as ‘swing’ oil producer

With some of the world’s largest and cheapest-to-access oil reserves – and spare production capacity of between 1-2mbd – Saudi Arabia has been the world’s ‘swing’ oil producer and the biggest single influence on the global oil market for decades. In view of the rise of US shale production, slower Chinese demand growth, and the drop in oil prices, the kingdom is having to resort to ever-higher-profile – and more risky – actions to maintain that role.

As recently as 2008─09, when oil collapsed to $35 a barrel, Saudi Arabia, in tandem with Organisation of the Petroleum Exporting Countries, was able to cut production and raise prices, while growing Chinese demand helped offset lower demand from the West.

In response to the oil price decline since 2014, however, Saudi Arabia has decided to increase production from 9.8mbd to 10.2mbd, while Opec has raised production to over 30mbd, thus keeping prices low.

ʻWarʼ on shale
To plug the resulting gap in its budget revenues – 80% of which depend on oil sales – Riyadh has heavily drawn down foreign exchange reserves (see Minuet on Saudis, oil and Russia).

While some see this as a strategic decision in the Middle Eastern struggle over political and religious influence, or as part of a ‘war’ on shale producers, in reality it reflects a tacit recognition of the supply-side shock that shale has introduced to global oil markets, which is affecting Saudi Arabia’s price-setting ability.

New shale wells can be drilled in around 7─10 days, compared to the several years needed for new conventional oil production. As a result, shale has flattened the supply curve and smoothed oil prices in the short term, because changes in demand and price can rapidly translate into changes in output. If the Saudis cut production and prices rise, US shale producers can increase production before conventional energy sources respond.

Despite the US having banned crude oil exports since the oil shock of the 1970s, increases in domestic production reduce US imports, creating global oversupply as exporters to the US battle for new markets.

Waiting for shale producers to succumb to low prices and cease production is not a realistic long-term goal. While some production is uneconomic at current prices, there is huge diversity among different shale projects. Dry gas is not worth the cost of production, but much of the natural gas liquids and crude oil from shale are profitable within the current price range. This explains why US production is still high despite the rapid decline in price.

In view of low oil prices, some shale producers are finding access to financing difficult. This may lead to a steeper output decline in coming months. However shale’s ability to increase production rapidly as prices rise – compared to the long-term and high overall cost of conventional oil production – means future price rises are likely to unlock this financing once again.

In future, these trends could challenge the multi-billion-dollar, long-term nature of global oil production. By flattening the supply curve, reducing the relative cost of bringing marginal new production online and shortening the time horizon, shale has affected funding, contract and pricing structures in the energy industry as a whole that is changing the way that large-scale energy projects are carried out.

Biggest losers
As one of the cheapest and largest oil producers, Saudi Arabia can withstand these challenges and remain the fundamental driver of global oil markets. The biggest losers are new oil and gas projects in expensive locations including Eastern Siberia, Canada and deep-sea locations.

However, the challenges introduced by the ability of US shale to respond quickly to price increases – and the resulting pressure on the Saudi budget, which is likely to result in further reductions in its still-large foreign exchange reserves – raise important questions over the future of Saudi Arabia’s stabilising role in the global economy.

Ben Robinson is Economist, OMFIF.

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