Why Saudi Arabia Will Lose The Next Oil Price War

Saudi Arabia has instigated two oil price wars in the last decade and has lost both. Given its apparent inability to learn from its mistakes it may well instigate another one but it will lose that as well. In the process, it has created a political and economic strait-jacket for itself in which the only outcome is its eventual effective bankruptcy.

The principal target for Saudi Arabia in both of its recent oil price wars has been the U.S. shale industry. In the first oil price war from 2014 to 2016, the Saudi’s objective was to halt the development of the U.S. shale sector by pushing oil prices so low through overproduction that so many of its companies went bankrupt that the sector no longer posed a threat to the then-Saudi dominance of the global oil markets. In the second oil price war which only just ended, the main Saudi objective was exactly the same, with the added target of stopping U.S. shale producers from scooping up the oil supply contracts that were being unfilled by Saudi Arabia as the Kingdom complied with the oil production cuts mandated by various OPEC and OPEC+ output cut agreements.

In the run-up to the first oil price war, the Saudis can be forgiven for thinking that they stood a chance of destroying the then-relatively nascent U.S. shale sector. It was widely assumed that the breakeven price across the U.S. shale sector was US$70 per barrel and that this figure was largely inflexible. Saudi Arabia also held record high foreign assets reserves of US$737 billion at the time of launching the first oil war. This allowed it room for manoeuvre in sustaining its economically crucial SAR-US$-currency peg and in covering any budget deficits that would be caused by the oil price fall. At a private meeting in October 2014 in New York between Saudi officials and other senior figures in the global oil industry, the Saudis were ‘extremely confident’ of securing a victory ‘within a matter of months’, a New York-based banker with close knowledge of the meeting. This, the Saudis thought, would not only permanently disable the U.S, shale industry but would also impose some supply discipline on other OPEC members.

As it transpired, of course, the Saudis had disastrously misjudged the ability of the U.S. shale sector to reshape itself into a much meaner, leaner, and lower-cost flexible industry. Many of the better operations in the core areas of the Permian and Bakken, in particular, were able to breakeven at price points above US$30 per barrel and to make decent profits at points above US$37 per barrel area, driven in large part through advances in technology and operational agility. After two years of attrition, the Saudis caved in, having moved from a budget surplus to a then-record high deficit in late 2015 of US$98 billion. It had also spent at least US$250 billion of its precious foreign exchange reserves over that period that were lost forever. In an unprecedented move for a serving senior Saudi politician, the country’s deputy economic minister, Mohamed Al Tuwaijri, stated unequivocally in 2016 that: “If we [Saudi Arabia] don’t take any reform measures, …then we’re doomed to bankruptcy in three to four years.”

The even more enduring legacy of this first oil price war, though – and part of the reason why the Saudis could never hope to win the last one, or any future oil price war either – is that it created the resilience of the U.S. shale sector as it now stands. This means that the U.S. shale sector as a whole can cope with extremely low oil prices for a lot longer than it takes Saudi Arabia to be bankrupted by them. Saudi Arabia has much greater fixed costs attached to its oil sector, regardless of how low market prices go. Before the onset of the latest oil price war, the Kingdom had an official budget breakeven price of US$84 per barrel of Brent but, given the economic damage done by this latest price war folly, it is much higher now. By stark contrast, the U.S. shale sector that Saudi crucially helped to shape in the first oil price war is now so nimble that US$25-30 per barrel of WTI is enough to bring some of the production back on line, as long as operators believe that prices will not fall and hold below the US$20 per barrel level. But, even if prices are below that key US$25-30 per barrel level, it does not matter to the long-term survivability of the U.S. shale sector as the key players are able to shut down wells instantly as and when needed and to start up them up again within a week as demand requires. In sum: in any oil price war, the Saudis simply cannot wait out the U.S. shale sector.

On the other hand, though – in a rising oil price environment - the Saudis are also doomed. This is because the U.S. – even before the latest oil price war – had intimated that it would not tolerate oil prices above around US$70 per barrel of Brent. When the oil price rose last year during the March-October period consistently above US$70 per barrel level, U.S, President Donald Trump Tweeted about Saudi Arabia’s King Salman that: “He would not last in power for two weeks without the backing of the U.S. military.” The US$70 per barrel level is considered one that brings into view oil price levels that might pose problems for the U.S. economy. Specifically, it is estimated that every US$10 per barrel change in the price of crude oil results in a 25-30 cent change in the price of a gallon of gasoline, and for every 1 cent that the average price per gallon of gasoline rises, more than US$1 billion per year in consumer spending is lost.