Saudi Arabia’s Double-Edged Gift for U.S. Shale
(Bloomberg Opinion) -- Saudi Arabia certainly put the “rollover” in, well, rollover on Tuesday. Having spent most of 2020 playing disciplinarian in the OPEC+ group, the oil giant took the hit itself at the end of the latest meeting. Ostensibly, supply cuts are being rolled over into February and March. In reality, Saudi Arabia will voluntarily cut its own supply, allowing most other members to reap the benefit of higher crude prices — and a select few to enjoy the bonus of loosened output caps, too. And by “select few,” I mainly mean Russia.
But there is one other group that benefits, one that haunts rather than sits at the OPEC+ table: U.S. oil companies.
Oil’s vaccine-inspired rally in late 2020 risked causing OPEC+ to start adding back supply this month, thereby capping the rally. Russia, which handles lower oil prices better than most other members, was pushing for this. Saudi Arabia, with an eye on resurgent Covid-19 cases and perhaps the risk of extra barrels produced in January hitting the seasonally weak spring market, led the resistance. The result is a compromise: Russia (and Kazakhstan) get some of the extra production allowance they wanted, the rest maintain their current levels, and Saudi Arabia takes one for the team — 1 million barrels a day, that is.
It’s a remarkable about-face from last year, when OPEC+ adopted a convoluted formula of make-backsies on any excess production by members and Saudi Arabia called out offenders by name (apart from the biggest, Russia). Besides the symbolism of this climbdown and the notional $3 billion of revenue Saudi Arabia forgoes with the extra cut (assuming $50 a barrel), there is an added sting:
One of the silver linings of the Covid crash for Saudi Arabia (and other OPEC+ members) was that it dealt a haymaker to an already-tottering U.S. oil sector. Investors had largely abandoned the group because of chronic mismanagement of capital, and it became the smallest sector in the S&P 500 for the first time. As the industry has begun to consolidate, cut budgets and at least talk the talk on prioritizing shareholders, it has sat up on the canvas. The oil price rally, now provided a further boost by Riyadh, has tempted back a few more speculative souls and allowed energy to nudge past real estate to be only the second-smallest sector.
That’s not exactly a full recovery, obviously, but the oil sector’s threshold for what constitutes success is at ground level these days. Highly leveraged companies such as Occidental Petroleum Corp. topped the U.S. energy leaderboard Tuesday, symbolizing the lifeline thrown from Riyadh. Importantly, longer-dated oil futures are now close to breaching the $50 level, last seen almost a year ago. Above $50, U.S. producers should feel comfortable hedging more of their future production.
This doesn’t portend a sudden rebound in shale output. Energy may no longer be the smallest sector in the S&P 500. But at less than 2.5%, it still has far to go in restoring trust with investors, and that means restraint on spending. Still, hedging more production at higher prices helps a lot, and this will stabilize U.S. oil output and put it on a sustainable upward path.
This has been the dilemma faced by OPEC, and OPEC+, for years — trading off market share for price. It may be less acute at this point given shale’s scars, but it remains. As OPEC+ members aim to bring back their own 7 million barrels a day of spare capacity after March, any extra U.S. barrels present competition.
And yet, looked at in the wider context, Saudi Arabia’s apparent capitulation isn’t a complete victory for shale. In one way, the size of the voluntary cut is itself unnerving, suggesting Riyadh fears the recovery in oil demand is more fragile than many think.
There is also the whiplash aspect to consider. Less than a year ago, OPEC+ effectively blew apart when Saudi Arabia launched a price war against Russia. Covid-19 forced a quick truce, which proved effective at putting a floor under prices. Yet strains quickly reappeared, most notably between Saudi Arabia and its traditional close partner, the United Arab Emirates. The adoption of a provision whereby producers make up any shortfall on compliance with their supply limits, as well as the move to monthly meetings — now adjusted again on Tuesday — speak to the mounting difficulty of holding such a disparate group together. The new arrangement, whereby Russia gets a partial free pass but others are still expected to play the game, and with Saudi Arabia reverting to underwriting the whole thing, takes this tension to a new level. As oil demand comes back, and prices rise further, such multispeed discipline looks unsustainable.
For frackers, who looked into the abyss when the last OPEC+ price war broke out, the possibility of a new one down the road should temper short-term enthusiasm. Saudi Arabia’s unexpected gift presents an opportunity for the shale sector to press on with fixing its problems, not abandon the effort altogether.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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