The Saudis Tried to Kill The Shale Oil Business. It May Turn Out The Other Way Around

This article on Saudi Arabia, shale oil, and oil prices was interesting throughout

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

Citizens pay no tax on income, interest, or stock dividends. Subsidized petrol costs twelve cents a litre at the pump. Electricity is given away for 1.3 cents a kilowatt-hour. Spending on patronage exploded after the Arab Spring as the kingdom sought to smother dissent.

The International Monetary Fund estimates that the budget deficit will reach 20pc of GDP this year, or roughly $140bn. The 'fiscal break-even price' is $106.

Far from retrenching, King Salman is spraying money around, giving away $32bn in a coronation bonus for all workers and pensioners.

He has launched a costly war against the Houthis in Yemen and is engaged in a massive military build-up - entirely reliant on imported weapons - that will propel Saudi Arabia to fifth place in the world defence ranking.

The Saudi royal family is leading the Sunni cause against a resurgent Iran, battling for dominance in a bitter struggle between Sunni and Shia across the Middle East. "Right now, the Saudis have only one thing on their mind and that is the Iranians. They have a very serious problem. Iranian proxies are running Yemen, Syria, Iraq, and Lebanon," said Jim Woolsey, the former head of the US Central Intelligence Agency.

Money began to leak out of Saudi Arabia after the Arab Spring, with net capital outflows reaching 8pc of GDP annually even before the oil price crash. The country has since been burning through its foreign reserves at a vertiginous pace.

  • Matthew Slyfield

    "vertiginous" Do you sleep with a thesaurus under your pillow?

  • STW

    That chart is quite an indictment of Venezuela too. Once again, apparently, a country failed to get the right people in charge to make socialism work.

  • kidmugsy

    The author of the quotation is British, and is therefore allowed - even expected - to write in an educated register.

  • Trevor

    If shale rose to its current position in large part on the back of The Fed's ZIRP, then will The Fed be credited with reducing Saudia Arabia to a minor player in geopolitics? Some professor at the Mises Institute has to be feeling both vindicated and perplexed.

  • morganovich

    the shale revolution is technology based.

    it has very little to do with zirp.

  • Trevor

    I won't argue with that. I'm keenly aware of the technology breakthroughs occurring. That said there are a number of companies that spent money acquiring and drilling acreage that is sub-economic at today's prices. Frankly, they were struggling to make money when oil was $100/bbl. These were companies that acquired acreage at the top of the market in areas outside of the core of shale basins. They wouldn't have been to do this if 1) the weak dollar hadn't driven the price of oil up and 2) if banks starving for yield in a low-interest environment hadn't lent them them the money. I would say shale is a product of both technology and low interest rates. In this case, they aren't mutually exclusive.

  • Matthew Slyfield

    "vertiginous" isn't educated, it's pompous.

  • Nimrod

    Yea, so strange how socialists just keep getting unlucky over and over again, repeatedly failing to get the right leaders who will "do it the right way" for once. But I'm sure they'll keep trying because eventually they'll get lucky and finally get that magical enlightened autocrat who knows how to do socialism the right way thus ushering in the age of socialist utopia.

  • Nimrod

    Arabia was a land of caravan operators and caravan robbers, and it still is. Once the filthy infidels developed the technology to utilize and drill for oil, the caravan robbers figured out that they were sitting on a pile of black gold. All they had to do was guard it from being stolen and thus impose enough of a cost on attempting to steal it that it would be easier for the filthy kuffar to just buy it.

    So they sell their pile of black gold and party, at least until the pile runs out. After that, well, the caravan operating business isn't worth much these days with modern transport technology so they'll return to an economy based on caravan robbing and piracy again.

  • morganovich

    trevor-

    again, i think you are very much overstating the role of the fed and misunderstanding the role of the dollar.

    there has been very little correlation with shale and the dollar. a 15% drop in the dollar was only a $7-10 hike in oil prices. most of it was enormous demand from china and productions controls from opec.

    banks have been lending less than before zirp. that's what happens when you force them to buy more tier one securities and when the fed grabs a ton of govvies and takes them out of the collateral pool for repos.

    QE actually caused a severe tightening in lending of credit. every bond taken out of circulation causes the repo market (a big source of bank short term financing) to shrink by about $3 (the effect is amplified by rehypothecation).

    credit for small firms has been far tighter under zirp and qe than it was before. in 2009-11, lending to small firms was almost entirely absent. the same is true now.

    some of the bigger guys were able to issue debt, but even more of the money was equity.

  • c_andrew

    I find it dizzying...

  • Matthew Slyfield

    Or maybe they'll just end up following Greece down the drain.

  • Roy_Lofquist

    The most significant entry in the chart is about Iran. They finally break out of the sanctions and their oil is worth less than production cost. They'd better hope that the pistachio market doesn't crash too.

  • NL7

    My understanding is that the Gulf elites are mostly diversified with respect to their own holdings, and that they have been for decades, so they should be personally fine. I assume much of the Saudi capital outflow is the elites moving their money out. But the countries will of course suffer greatly as they transition from "rentier states" to more typical states.

    My Middle East politics professor used to say that the Gulf states had enough welfare "to make a Scandinavian blush" and that even long distance phones were free in Kuwait at one point. He stopped to make a call in the Kuwait airport and asked a stranger how to pay. The answer was he didn't pay, he just picked it up and made a free international call, back in the 90s.

    There are also hospitals and facilities across Africa and Asia paid for by rich oil states trying to buy friends. Many of them were underused or closed entirely, because the recipient countries lacked the money, experts, or technology to make full use of them.

  • Vangel

    No shale company had made an economic profit even when oil prices were above $ 80 per barrel. Shale is a scam outside the now mostly depleted core areas. Sorry follow children but the game diez with the bond bubble.

  • Vangel

    Socialists? Do you mean the central bankers that made both the shale fraud and Saudi Arabian borrowing possible?

  • Vangel

    Iranian oil will be fine. Shale producers will not be.

  • mesocyclone

    Shale is now profitable at $45/bbl in the Permian Basin.

  • marque2

    Why? They are still going strong producing more and reducing costs. This year they expect another 45% drop in costs, and production is actually increasing at $50 a bbl. Not a sign of an industry going away. They said the same about shake gas 5 years ago and production has increased 30% since then.

    What is your beefvwith shale gas? You own traditional oil stock?

  • marque2

    You mean sesquipedalian.

  • Vangel

    Why? They are still going strong producing more and reducing costs.

    Your 'going strong' comment should cause a few alarm bells to ring. Let me explain. (If you think I am not clear or wrong please respond and we can discuss the points of disagreement.)

    Let me begin by noting that I have been looking for more than ten years and have yet to see a primary producer of shale oil and gas generate positive cash flows even when prices were over $80 and $10 respectively. If you can provide evidence that I am wrong please let me know but let me assure you that the 10-Ks have not been very encouraging.

    Let me also note that there are some great wells that have high returns but they are in the core areas, which are tiny and mostly played out. For shale to be viable the average well has to be economic. And that is the problem.

    What I have seen are assumptions by analysts of hyperbolic declines that produce EURs that are not supported by the actual production data. As such you have accountants write off a third of the cost of a well that has already yielded 60% of all the oil that it will ever produce. The assumption of 25 years of low but steady production after the steep decline has ended is not supported by evidence.

    I think that we will have to see balance sheet revaluations that will drive most shale players into insolvency, probably after the high yield debt market destroys a few more holders of shale company debt.

    Note that the shale revolution has always been funded by massive debt that was plentiful thanks to the Fed's activities. When good old Aubrey McClendon was hyping shale gas as the next great thing most of the companies that were drilling for gas relied on debt to close their funding gaps. They overproduced and as supply exceeded demand the prices tanked. A skeptic would clearly ask why did McClendon and his competitors produce so must to create a glut and why did they continue to produce?

    The very scary answer is simple. The producers could not stop production to stabilize prices because they could not make the debt payments.They kept pumping and borrowing, pumping and borrowing…, and pumping and borrowing until the lenders said stop. Note that the lending has not quite stopped yet. After a false bit of sanity investors that were lured by the promise of high yields bought billions of new debt in individual issues only to find that the recent price decline wiped out $7 billion of the market price of high-yield debt in the energy sector.

    http://www.bloomberg.com/news/articles/2015-03-17/energy-junk-bond-revival-cut-short-as-7-billion-lost-in-10-days

    Once the technicals align with the geological and economic reality shale will be toast. Thanks to the Fed, shale has become one of the greatest capital destroyers in history. Even worse, the shale bubble discouraged much needed real investment in the energy space. While prices could fall more conventional fields lose around 4% of their production capacity each year unless there is new investment taking place. With that investment drying up we are looking at a massive spike once the carnage has run its course. Worse yet is the damage that the Fed has done to the coal space. By encouraging uneconomic production in gas and the substitution of cheap gas for coal the Fed has forced may companies to close mines and declare bankruptcy. I am sure that some mines abroad have been sold to foreign players who are more patient and not as foolish. But in the end the collapse in shale production will have to be replaced by something else. How does that happen if the USD is in trouble and rates are high?

  • Vangel

    Really? Show me a single producer in the shale space that can generate positive cash flow. I know that I have looked for them for around ten years and still can't find one. Note that you can show a profit as long as you don't count all the costs but that game does not last very long. And given the fact that the banks are reviewing the credit lines this coming October you are going to be looking at a massive collapse in the shale space that has been long overdue given the horrible results even when oil was $100 per barrel.

    Also note the sleight of hand. Ten years ago the big hype was about gas because that is easier to produce in tight formations like shale. But that was such a disaster that companies tried to sell themselves as liquids plays. Now that the hedges are winding down and the actual prices received are $30-$40 lower most producers will be officially bankrupt within a year.

  • marque2

    You realize all the oil shale is currently protected by futures @ approximately $110 per bbl and these contracts won't disappear until the end of this year?

    And yes, that is how businesses work, you borrow money to do construction and the. Pay back the loans, you make it sound nefarious.

    Ah well, you could be right, but I must point out, the same thing was said about shale gas when the price collapsed. Drilling declined dramatically and wells which were suppose to dry up in 24 months are now producing 30% more.

  • marque2

    And yet 30% more gas is produced since the crash .

    I think you are confusing things. You should take some business courses, you will learn that there are several stages to a business, it starts out in an innovation stage, where the company does nothing but lose money, it transitions to growth where the company is investing all into more production so either makes little money or a loss, and then the company matures and you get the cash cow phase where borrowed money is paid back, investors get nice dividends and money is used to research the next innovation.

    Shale oil was in the early growth phase, of course they were borrowing money, and when the Saudis caused the price drop, they transitioned early to a cash cow phase where investment in new production declines and efforts are made to minimise costs. They have done a good job.

    Of course some will fail, maybe in about a year when the futures contracts run out, but those will be sold to someone at a discount where they will be able to produce profitably at a lower cost base.

    Actually the Saudi move is quite healthy for the industry since it is forcing them to develop technologies and techniques that maximise production per dollar cost.

    Anyway, we heard the same thing about Amazon years ago, they are losing money, year after year, they will never make it. Apple as well, though ten years prior.

  • Vangel

    I am aware of the hedging practices but I also know that not all companies have hedged their production at anywhere near $100. I also know that your comment should be setting the alarms off because of the 10-Ks don't show positive cash flows at $110 what happens at $50?

    And if you want to see what happened to shale gas producers look to CHK. It will be gone in the next year because even after all of the asset sales it is unable to close the funding gaps without massive borrowing. As for 24 months, shale gas wells decline by around 70% in the first year, not 24 months. Whatever bad news you think is coming, it is a lot worse my friend.

    Note that it is easy to prove me wrong by doing what I could not do; find primary shale producers that can generate positive cash flows.

  • Vangel

    And yet 30% more gas is produced since the crash .

    Correct. That is what you get when you can fund production by borrowing in order to make the interest payments on the debt.

    I think you are confusing things. You should take some business courses, you will learn that there are several stages to a business, it starts out in an innovation stage, where the company does nothing but lose money, it transitions to growth where the company is investing all into more production so either makes little money or a loss, and then the company matures and you get the cash cow phase where borrowed money is paid back, investors get nice dividends and money is used to research the next innovation.

    LOL...There is nothing left for investors because the core areas that are profitable are depleted and the average well in the formation is not economic at triple the current prices for gas or oil. One of the things that business school teaches you is that you have to include ALL OF THE COSTS when looking at the economics of a process of production. As I pointed out, the accountants assumed high EURs that are not supported by the production data. That means that they did not apply the full depreciation as they should have. The last time I noticed this was when I looked at Nortel and came up with a value of around $0.70 for a company that was selling for $80 and on its way to $120. Everyone laughed because I was very wrong. And they were right. The company fell to less than $0.10 because of sentiment and because my assumptions were too optimistic.

    Shale oil was in the early growth phase, of course they were borrowing money, and when the Saudis caused the price drop, they transitioned early to a cash cow phase where investment in new production declines and efforts are made to minimise costs. They have done a good job.

    A good job? Debt has exploded and the shale oil from the wells that were drilled is gone. Free cash flows were negative even at $100 oil even though shale well production profiles show that most of the revenue would be produced in 24 months. What would a bad job look like?

    Of course some will fail, maybe in about a year when the futures contracts run out, but those will be sold to someone at a discount where they will be able to produce profitably at a lower cost base.

    Sorry my friend but most will fail. The non-core areas are not economic at $250 oil because the energy needed to drill the wells is greater than will be extracted from the oil that they produce after royalties are paid. As I said, proving me wrong is very easy. Find evidence that companies have been able to generate free cash flow from shale operations. If you can't it may be time to be a bit more skeptical.

    Actually the Saudi move is quite healthy for the industry since it is forcing them to develop technologies and techniques that maximise production per dollar cost.

    The technology has been around a long time. Some of the techniques are new and a big improvement but they cannot overcome the fact that non-core area wells don't produce much oil.

    Anyway, we heard the same thing about Amazon years ago, they are losing money, year after year, they will never make it. Apple as well, though ten years prior.

    Amazon can't generate much in the way of cash flow either and has paper thin margins that make it one of the most overvalued stocks in the market. It is a great company that I use but I have no illusion about making a profit from its shares. During the next correction it should shed around 80% of its current market valuation (in real terms) but should survive. The shale players will not.

    As for Apple, it was saved by two things, iTunes, and the iPhone. Since it can generate cash flows and has plenty of cash on hand it might be able to ride out the storm and come out stronger on the other side unless some really smart 14 year old comes up with a new killer system that becomes a threat.

    If you want to make a few bucks in the markets I would stay away from overvalued players and look to something like the gold royalty players. And once oil recovers and explodes to the upside expect to see a massive increase in the value of the conventional players. Picking up shares in coal companies that survive should be very profitable during the next move.