The Looming Bankruptcy Of Saudi Arabia

by Tim Worstall for Forbes

There’s two interesting little stories in this idea that Saudi Arabia is going to go bust in a couple of years as a result of the sagging oil price. Both are more general economic ideas than just the story of that oil price. The first is that mono-anything in economics is something we don’t really like. We certainly don’t like either monopolies or monopsonies, but we should also be very careful of an economy that relies on any one product or even supplier. The perils of resting an entire economy on the production of just the one commodity should be obvious here. But the same could and should be said about reliance upon any one supplier in an economy as well. We want diversity, always, of producers and suppliers. The second is that this is an object lesson in why most economists don’t really believe in the idea of predatory pricing. Sure, it’s possible for a dominant supplier to try to lower prices and drive others out of the marketplace. The idea is that once they’ve bankrupted those others then they can sweep back in, raise prices and thus enjoy monopoly profits having killed the competition. There’s an element of Saudi having tried this, trying to kill off shale. And it’s not working: and economists have never really seen anyone making this tactic work. Which is why they don’t really believe in it as anything other than a theoretical possibility.

So here’s Ambrose Evan Pritchard: and it should be said, love him dearly though we do, he can be just a little over enthusiastic about his latest idea:

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.
The contract price of US crude oil for delivery in December 2020 is currently $62.05, implying a drastic change in the economic landscape for the Middle East and the petro-rentier states.
The Saudis took a huge gamble last November when they stopped supporting prices and opted instead to flood the market and drive out rivals, boosting their own output to 10.6m barrels a day (b/d) into the teeth of the downturn.
Bank of America BAC -0.34% says OPEC is now “effectively dissolved”. The cartel might as well shut down its offices in Vienna to save money.
If the oil market had had its old structure, where projects take a decade or more to even bring into production and then produce for decades more, at vast capital cost, then the sort of tactic that Saudi used might have a chance of working. If by flooding the market for a year or two Saudi can cast doubt on the financing of the next wave of such large projects then they might be able to enjoy a decade or more of high prices. Those high prices more than making up for the lost income in that period of undercutting those projects. Maybe.
But fracking is a very different production method, as I suggested back here:

In the past, observers and analysts viewed resource production as an extraction business in which costs and prices rise over time as the better low-cost prospects tap out. Fracking has changed the situation completely. Fracking is manufacturing or, perhaps better, “manufRacturing.” It is not resource extraction. Historically, manufacturing is characterized by increasing productivity and falling costs.

Furthermore, manufacturing typically begins in more advanced industrialized nations and then spreads over time to other countries. Cotton ginning started in the United States after Eli Whitney invented the first modern mechanical gin in 1793. The practice then spread to other countries. Advanced steel production began in the US after World War II and then took hold in Germany, Japan, South Korea, and China. Industrial revolutions move from high-cost countries to low-cost nations. We expect crude oil manufacturing to do the same.

The point being that a fracking well just isn’t a high capital cost operation. Nor is it something that you need long term high prices to justify. We’re down to single digit millions to drill one these days, the vast majority of the return comes in the first couple of years. This thus moves us away from the traditional resource production financial model over to something much more resembling manufacturing. And as AEP points out, the costs of this are dropping all the time:

The problem for the Saudis is that US shale frackers are not high-cost. They are mostly mid-cost, and as I reported from the CERAWeek energy forum in Houston, experts at IHS think shale companies may be able to shave those costs by 45pc this year – and not only by switching tactically to high-yielding wells.

Advanced pad drilling techniques allow frackers to launch five or ten wells in different directions from the same site. Smart drill-bits with computer chips can seek out cracks in the rock. New dissolvable plugs promise to save $300,000 a well. “We’ve driven down drilling costs by 50pc, and we can see another 30pc ahead,” said John Hess HES +1.59%, head of the Hess Corporation.

It was the same story from Scott Sheffield, head of Pioneer Natural Resources PXD +2.13%. “We have just drilled an 18,000 ft well in 16 days in the Permian Basin. Last year it took 30 days,” he said.

Far from that traditional resource model of projects becoming ever more expensive we’re now in a low capital consumption and highly reactive world. Any resumption of high oil prices is just going to see those fracking wells increase in number and thus production to come into the market. In effect Saudi is no longer the swing producer and no longer the price determinant on the upside. If Saudi did restrict production to raise prices the major beneficiaries would be those shale drillers.

So, Saudi Arabia opened the pumps to try to kill off shale: the end result is that shale keeps working and any price rise will be met by increasing production from them.

As I say, economists tend not to believe in predatory pricing as being a useful real world technique for exactly this reason: it doesn’t so far as we’ve ever seen, lead to a profit for the predator. And, as AEP points out, this is going to cause terrible problems for Saudi Arabia in the near future. To balance their budget they need oil at $106 per barrel. And it’s extremely unlikely ever to reach that level again, given that fracking has transformed the industry into something much more akin to manufacturing than resource extraction.

Some of this is of course detail about the oil industry. But the real story here is, well, what does an economy do when 90% of it is indeed oil based and the price of oil has more than halved and looks as if it will never recover?

Quite, diversity in an economy is to be desired.

Source: The Looming Bankruptcy Of Saudi Arabia