Was our Saudi sheep farm wasted money whatever happened?

Stephen Franks on the Saudi central bank's latest stability report.

A startlingly blunt report in the Telegraph says that “If the oil futures market is correct, Saudi Arabia will … be in existential crisis by the end of the decade“.

If correct it also makes our ‘ investment’ in a desert sheep farm to secure a FTA look unrewarding. Even if the bribe had secured the the FTA instead of exploding in our faces with more ill will and mistrust, the Telegraph scenario would have Saudi Arabia unable to buy much from us within this decade.

The report says:

” 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 10.6 million barrels a day (b/d) into the teeth of the downturn.

Bank of America says OPEC is now “effectively dissolved”.  

If the aim was to choke the US shale industry, the Saudis have misjudged badly…” 

The Saudi central bank’s latest stability report is cited:

“The main impact has been to cut back on developmental drilling of new oil wells, rather than slowing the flow of oil from existing wells. This requires more patience,” it said.

But it appears that everyone has misjudged the extraordinary inventiveness of the US drillers who created and are still developing the fracking miracle.

“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 45 per cent 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 $US300,000 a well. “We’ve driven down drilling costs by 50 per cent, and we can see another 30 per cent ahead,” said John Hess, head of the Hess Corporation.

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

You have to be awed at an industry that can innovate as fast as the US drillers. The report cites an insider’s warning that:

the resilience of the sister industry of shale gas should be a cautionary warning to those reading too much into the rig-count. Gas prices have collapsed from $US8 to $US2.78 since 2009, and the number of gas rigs has dropped 1200 to 209. Yet output has risen by 30 per cent over that period.

… even if scores of over-leveraged wild-catters go bankrupt as funding dries up, it will not do OPEC any good.

The wells will still be there. The technology and infrastructure will still be there. Stronger companies will mop up the cheap, …. Once oil climbs back to $US60 or even $US55 – since the threshold keeps falling – they will crank up production almost instantly.

OPEC now faces a permanent headwind. Each rise in price will be capped by a surge in US output. The only constraint is the scale of US reserves that can be extracted at mid-cost, and these may be bigger than originally supposed, not to mention the parallel possibilities in Argentina and Australia, or the possibility for “clean fracking” in China as plasma pulse technology cuts water needs.”

The result?

“Saudi Arabia is effectively beached. It relies on oil for 90 per cent of its budget revenues. There is no other industry to speak of, a full fifty years after the oil bonanza began.

The article goes on to highlight the costs of the Saudi royal family’s leadership of the Sunni cause in the bitter struggle between Sunni and Shia across the Middle East.

“The country has  been burning through its foreign reserves at a vertiginous pace.

The reserves peaked at $US737 billion in August of 2014. They dropped to $US672 billion in May. At current prices they are falling by at least $US12 billion a month.

It then cites Standard & Poor’s negative outlook:

“We view Saudi Arabia’s economy as undiversified and vulnerable to a steep and sustained decline in oil prices,” it said in February.

The Telegraph concludes:

“The Saudis are now trapped. Even if they could do a deal with Russia and orchestrate a cut in output to boost prices – far from clear – they might merely gain a few more years of high income at the cost of bringing forward more shale production later on.

Yet on the current course their reserves may be down to $US200 billion by the end of 2018. The markets will react long before this, seeing the writing on the wall. Capital flight will accelerate.

The government can slash investment spending for a while – as it did in the mid-1980s – but in the end it must face draconian austerity. It cannot afford to prop up Egypt and maintain an exorbitant political patronage machine across the Sunni world.

Social spending is the glue that holds together a medieval Wahhabi regime at a time of fermenting unrest among the Shia minority of the Eastern Province, pin-prick terrorist attacks from ISIS, and blowback from the invasion of Yemen.

Diplomatic spending is what underpins the Saudi sphere of influence caught in a Middle East version of Europe’s Thirty Year War, and still reeling from the after-shocks of a crushed democratic revolt.

We may yet find that the US oil industry has greater staying power than the rickety political edifice behind OPEC.”

But Peak Oil will rescue them, no doubt.

Thanks Phil for drawing this to my attention.

Stephen Franks is principal of Wellington commercial and public law firm Franks and Ogilvie.

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