OPEC’s catch 22

This is not my first post on the current oil price dilemma and I have a hunch that there will be more to come in terms of even lower prices. From today’s vantage point it looks a bit like the new ruler of the kingdom has stabilized the slide but nothing could be further from the truth as this fact, important as it is in many other ways has very little if no perceptible effect on the oil price.

Some of you will quip that I write a lot on oil for an LNG guy but worry not. Crude oil is still the threshold all other fuels are judged by so anything that happens to the black goo comes with a vengeance to LNG too.

Casual observers of the scene might quickly conclude that choices for the premier oil-selling club of the planet are strikingly simple and that Saudi Arabia has its options clear-cut on the table. Surprisingly, this is not very far from the truth except that the choices are clear at first sight. One must intimately understand the nature of the shale revolution – what do I say, one must understand what entrepreneurial spirits have done to the oil patch.

Typical OPEC member country NOCs are rather large bureaucracies and not beacons of entrepreneurialism.  They can’t be as this is not what they are here for. Their mission is to provide revenue for the government and jobs for the population.

Saudi Arabia was blasted by its peers (some of them at least) for not wanting to prop up prices. Let’s look at the options.

Going for higher prices now would mean curtailing supply so that the law of scarcity inflates prices again. That would give everyone more buck for the barrel but there would be fewer barrels so in the short run, this option will nevertheless produce pain. Budgets in oil-selling countries have been planned on the assumption of a certain number of barrels sold at a certain price.

Reduce one of those two factors and trouble strikes, reduce both and mayhem takes over. Most oil sellers’ skins are already paper thin so their tolerance for even stronger pain is extremely limited at the very best.

Let’s look at the other side of the coin. Those nasty shale drillers need to be annihilated or so must be the dominant thinking pattern in a classical oil seller’s brain. Let’s keep prices very low for a while and they will go out of business as we still produce cheaper oil.

And it’s exactly here where everything goes off the rail. The real threshold of an OPEC seller’s costs is not the technical price of getting black goo out of the ground but rather what the national budget needs not to collapse.

Some shale producers have called it quits and have either gone bankrupt or shed an enormous workforce. But the overall picture is still one of shale oil drillers going on with their business as if not much had happened. There are plenty of reasons for them: sunk investments, rapid deployment, and startup when prices go up again and wind down of shale wells or others are just the cherry on top.

The situation for oil producers is far worse as they are in a horrible bind. Let’s have a harder look at the underlying dynamics of shale. Shale has been around for more than a century (well that’s at least the time since we know it’s there and can theoretically be produced). One of the first shale oil wells was spudded in Austria in the 19th century and Empress Sissy was present. That’s some years in the past by now.

Conventional wisdom held that shale is there and plenty of it but that it would be too expensive to produce so we better stick with what we got from the Gulf or Russia or – you name it. That is old history now. A couple of renegade drillers defied the laws of upstream development and squeezed the cost stack to the point where shale became what it is today. Costs have tumbled almost 10-fold and even more in certain places. But who said that the journey was over?

Let’s face it. This is not “I got more oil than you” kind of game. It’s rather a “there is plenty of the stuff and I can get it out cheaper than ever before”. The game change is earth-bending as for the first time in history, national Oil Producers are faced with real oil entrepreneurs. The classical International Oil Companies they had to deal with so far are pretty bureaucratic organizations. They do not differ strongly from their NOC brethren in that respect. No wonder they don’t know how to react.

Because their simple world dictates that as the price of oil goes lower, more of the shale producers will fall under their profitability threshold and will hence bite the bullet and go out of business. For classical oil companies that might be the case but real oil and gas entrepreneurs are made of different matter.

Under pressure, they don’t buckle up and get out but rather grit their teeth and squeeze the lemon all the harder. They get creative with cost-cutting and if there is one thing to never be underestimated, it’s an entrepreneur that is fighting like hell to avoid default. For some of those guys, there is no going back, no warm and fuzzy office they can spend the rest of their lives in cushioned from the cruel world.

They are like cornered dogs and will fight like raging bulls. Not someone you want to square off with but that’s exactly what OPEC thinks it must do.

Raising prices would ease the pain for the shale roughnecks and make them purry pussycats again. But they will swamp the market OPEC thought it could have alone so there is no relief in that either.

Lowering prices on the other hand will squeeze shale producers into the corner but also transform them into bloodthirsty beasts that will fight like circus lions on a yoghurt diet in a Roman theatre.

There is no easy fix to this. Pandora’s Box has been opened and what has befallen classical oil producers cannot be put back anymore.

The recent price rally has brought back a lot of shale-producing capacity to the market which is further proof that shale is much more reactive than anyone dared to guess before the drop. Whatever OPEC can do to lift prices will be shaven immediately by shale producers and prolonged lower prices will kick shale producers into better shape making them a much more serious opponent.

Let’s not forget that even the current mini-price spike is not enough for virtually all producers to balance their budgets.

Producing countries will have to realize that the free lunch is over for good and that in the future they will have to resolve their budgetary problems in other ways than throwing loads of oil cash on everything.

What does this mean for LNG?

That’s easy. If high oil prices are toxic to OPEC (and some non-OPEC folks as well) as it stirs the new flock of shale entrepreneurs in action, they will eventually come around and accept the new reality. But this means that scores of LNG projects today are unsustainable with the current pricing regime and lifting prices to the levels needed to break even would curb the world’s thirst for LNG.

The world is coming to its senses again and oil will adapt. LNG will follow suit or suffer the consequences.