How Long Will Low Oil Prices Continue?

By Jeff Ronne

The Saudis are going insure that this low oil price drop lasts for quite sometime maybe a year or two.   The Saudis are going to attempt to and probably bankrupt many USA shale producers and their investors.  USA shale production is the threat that the Saudis are trying to contain.

The USA shale producers rely on leverage, borrowed money from the banks, seed capital from investors and moderate to high oil prices to stay solvent.

The Saudi induced price drop will last long enough to exhaust oil pricing hedges, last long enough to cause banks to tighten credit, last long enough to cause investors to seek greener pastures.  The price drop will last until it gets these needed results.  This will probably take 6 months to upwards of two years depending marketplace reaction.  Most USA shale is hedged 3 to 6 months out dropping steadily to very low levels after 1 year.

Then after oil prices rise again, the banks and investors will likely not fund USA shale producers again because they know if they do, the Saudis will screw them again.   It is not a question of if but when.

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The Saudis can not absolutely control the long term price of oil but they can inject oil price volatility into the market which impacts the risk analysis and increases the margin of safety demanded by investors to fund new oil exploration anywhere.   For instance now some oil futures contracts are selling in the $30 range which would have been unthinkable 1 year ago.   This is because the implied long-term oil price volatility has increased.  The Saudis are just trying to contain the growing global production of oil as best they can.  This growing global production is negatively impacting future Saudi wealth.

This is how business and economics works in the real world.   So here we are at the present, a guaranteed glut of oil supply courtesy of the Saudis and OPEC for the near term future.

So what is the likely oil price going forward to achieve the required Saudis goals ?

• The most important fact is the cost of Saudi production is between $10 and $15 a barrel.
• Many USA shale fracking operations have costs approaching $60 to 70 / barrel funded with borrowed money.
• Some USA shale fracking operations have costs as low as $40 / barrel.
• The likely Saudi price target is likely in the mid 40’s for this reason as it will severely curtail most if not all USA shale fracking as well as high cost oil production elsewhere in the world.
• These highly leveraged players all around the globe will likely fold in the coming years as investment capital flees and banks do not ante up with loans to fund continuing operations.

This is the sole reason why the Saudis will deliberately leave prices low for a few years to caution future investors in funding new USA shale fracking operations.  This is how the capital markets function, they operate on risk, reward and the expected future returns. The Saudis have let everyone know that they will not tolerate high cost producers in the oil market ever again.

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So if oil prices ever trend back up to $100 barrel expect the shale oil producers to be sleeping with one eye open.
Until usa shale production costs come down to a level lower than the Saudis are willing to produce at, the Saudis will remain in control.

On the geopolitical side we have the oil price numbers for each nation for budget breakeven

$80 / barrel for the Saudis
$105 / barrel for the Russians
$125 / barrel for Venezuela

and Iran is in a world of hurt begging at the bargaining table for sanction relief.

As of 1/6/2015 oil is below $50, and the process is accelerating which is great for the USA and the Saudis because the Russians and the Iranians will surrender sooner as opposed to later because they know at this point the Saudis have won.  Delay in negotiating with the West will just increase the financial pain without any benefits.
The Saudis have enough fiscal sovereign reserves to play this game for a few years even if oil drops to $20.  The Saudis have repeatedly publicly stated this just to assure investors and markets know they are not bluffing.  Clarity and certainty of purpose is honored in the marketplace.

More details are found in the article Sheikhs v shale