The OPEC (led by Saudi Arabia, other major producing countries including UAE, Iran, Iraq etc) was once the largest oil producer. Since the past two decades, with the increasing demand which resulted in rising oil price, and the drive to cut back on the dependence on oil imports, Russia, the US, as well as other countries resumed researches and investments for alternative/renewable energy and different methods of extracting oil. This fueled the rise of the oil shale industry, which involves mining and processing of oil from shale rocks. However, at higher cost in producing each barrel, the only incentive for shale producers to generate supply is when both the demand and the price of oil are high.
The shale producers run a lucrative business when the price is at the highest and supply as much as possible, but their counterparts in OPEC extracting oil from offshore have the same interest as well. However, they could not both achieve optimization by adopting the same strategy and enjoy the maximum profit. Thus the leaders in OPEC planned a way to regain the market by adopting the game theory model: price war - to compete at a cost of its own profits in order to drive down oil price and to undermine competing producers. This was a favorable strategy for OPEC (mainly Saudi Arabia) as it only costs $25-$30 USD per barrel to extract conventional oil from the Persian Gulf, as opposed to about $55-60 USD per barrel from shale oil production. Hence, as long as the oil price remains below mid 50s, shale producers would find themselves unprofitable and eventually be forced out of the market (note: Many shale producers are partnership funded by investors, and investors focus on dividends and returns from private business periodically)
In basic economic fundamentals, when supply exceeds demand, price goes down. Controlling the supply was exactly how the OPEC drove down the price of oil. Since the middle of 2014, OPEC decided to remain or even to increase production despite weaker demands due to slowing global economic growth. This caused a sharp decline in oil price, from $115 in July 2014 to $59 in December 2014. In 2015 OPEC continued to over-produce, which caused many shale producers to halt dividends and discontinue investments and projects. The downward momentum in price persisted into late 2015 when the price finally tumbled below $40, leaving not only shale producers to exit the business, but the revenues of many major oil producing countries also drastically reduced. With the cost of oil production, countries like Russia, Nigeria, Mexico, Canada, and Brazil are not be able to break-even and any production is operating under negative profit margin.
A simple table below explains the price war in Game Theory:
Profit/bbl: OPEC, Shale Producers
| OPEC | OPEC | ||
| Maximize Production | Control Production | ||
| Shale Producers | Maximize Production | Price: $35 $5, |
Price: $75 $45, $15 |
| Shale Producers | Control Production | Price: $65 $35, $5 |
Price: $115 $85, $55 |
For countries with oil export as a large source of revenue, the price war can turn the economies into deficits or even on verges of collapses. Even for Saudi Arabia, as the country had been spending heavily for the war in Yemen as well as addressing its own issues in the country, the tumbling oil price will only hurt the economy further. In the end, did Saudi Arabia win in the price war and eliminate competitions? Yes; but the bigger question is: when 80% of the country’s revenue comes from oil sales, is this the best strategy to adopt?
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Update Jan 21 2016
Some updates on the continuation of the oil price turmoil:
Saudi Arabia
‧ Reported second quarters of trade deficits at -$8bil USD, albeit favorable comparing to the previous quarter of -$11bil USD
‧ Plans an IPO of Aramco, the state-owned oil giant, in order to find capitals for its exploration and production assets
‧ Plans to issue debt for the first time to fund budget deficit
‧ In talks with the two largest Chinese petroleum companies, China National Petroleum Corp (PetroChina) and China Petroleum & Chemical Corp (Sinopec) to invest in projects to build refineries in China.
Iran
‧ Sanctions have been lifted and Iran can return to the world oil market; plans to ramp up production to 500K barrels a day
Venezuela
‧ Requested an emergency OPEC meeting to discuss plans to curb productions in order to drive prices back upward
‧ As petroleum represents more than 95% of the country’s exports and 38% of total GDP, at current rate the export will generate $27bil in this year, down from $75bil two years before
‧ The country owes over $10 bil in debt payments and is on the brink of going to default
‧ With high inflations and shrinkage, the government can’t pay to import basic food items
United States
‧ As of Jan 15, inventories rose to a record level of 485.2 million
‧ 40 companies have filed for bankruptcy
‧ Oil boomtowns like Pearsall, TX., and Fargo, ND. have turn into ghost towns
‧ Output is expected to reduce drastically
Europe
‧ Oil giant Royal Dutch Shell saw profits tumbled 40%, has reduced 7,500 jobs last year and plans for additional reductions.
‧ Competitor BP plans to eliminate 4,000 positions exploration and production jobs, in additions to 4,000 job cuts from previous year
As price drops below the psychological significant level of $30, producers are getting gloomier at the potential recovery and shutting down production as current contracts are fulfilled. The turmoil also sends the currencies of the petrostates (petroleum as a large % of state revenue) to record low against the USD. IMO, Saudi's plan to continue draining reserves, producing at an 80% discount in order to dominate market share to the point of borrowing to fund budget deficit, is an imbecile move. I suspect that they will have trouble getting great rates: given the country's budget dependency (or lifeline) on a commodity that they are willing to drain and destroy the price at anytime. Think about it this way, who wants to buy Apple's stock if the company willingly discounts its iphone price by 80% anytime just to start a price war with other phone makers?
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