Contributor: Elias Hinckley
Saudi Arabia’s decision not to cut oil production, despite crashing prices, marks the beginning of an incredibly important change. There are near-term and obvious implications for oil markets and global economies. More important is the acknowledgement, demonstrated by the action of world’s most important oil producer, of the beginning of the end of the most prosperous period in human history – the age of oil.
In 2000, Sheikh Yamani, former oil minister of Saudi Arabia, gave an interview in which he said:
“Thirty years from now there will be a huge amount of oil – and no buyers. Oil will be left in the ground. The Stone Age came to an end, not because we had a lack of stones, and the oil age will come to an end not because we have a lack of oil.”
Fourteen years later, while Americans were eating or sleeping off their Thanksgiving meals, the twelve members of the Organization of the Petroleum Exporting Countries (OPEC) failed to reach an agreement to cut production below the 30 million barrel per day target that was set in 2011. This followed strenuous lobbying efforts by some of largest oil producing non-OPEC nations in the weeks leading up to the meeting. This group even went so far as to make the highly unusual offer of agreeing to their own production cuts.
The ramifications of this decision across the globe, not just in energy markets, but politically, are already having consequences for the global landscape. Lost in the effort to understand the vast implications is an even more important signal sent by Saudi Arabia, the owner of more than 16% of the world’s proved oil reserves, about its view of the future of fossil fuels.
Since its formal creation in 1960 the members of OPEC, and specifically Saudi Arabia (and in reality the Kingdom’s control over global oil markets is much larger than that 16% of reserves implies as its more than 260 billion barrels are among the easiest and cheapest to extract and before enhanced recovery techniques accounted for a much larger share of global reserves) have used excess oil production capacity to influence crude prices. The primary role of OPEC has been to support price stability. There are notable exceptions – like the 1973-1974 oil embargo and a period of excess supply that undermined prices and crippled the Soviet Union in the 1980s (though whether this was a defined strategy or serendipity remains in some question), but at its core the role of OPEC has been to control oil prices. As recent events show, OPEC’s role as the controller of crude oil pricing is coming to an abrupt end.
In acting as global swing producer, OPEC relied has heavily on Saudi Arabia, which can influence global prices by increasing or decreasing production to expand or reduce available global supply. Saudi Arabia can do this not only because it controls an enormous portion of global reserves and production capacity, but does so with crude oil that is stunningly inexpensive to produce compared to the current global market. A change, however, has occurred in Saudi Arabia’s fundamental strategic approach to the global oil market. And this new approach – to refuse to curtail production to support global prices – not only undermines OPECs pricing power, but also removes a vital subsidy for global oil producers provided by the Saudi’s longtime commitment to price support.
The widely held conventional theory is that the Saudis want to shake the weak production out of the market. This strategy would undermine the economic viability of a meaningful amount of global production. The theory assumes that this can be done in some kind of orderly bring-down of prices where the Saudis can find an ideal price below the production cost of this marginal oil production but still high enough to maintain significant profits for the Kingdom while this market correction plays out. The assumption is that following the correction there will be a return to business as usual along with higher prices, but with Saudi Arabia commanding a relatively larger share of that market. An alternative rationale is that Saudi Arabia is fighting an economic war with oil; a strategy designed to economically and in turn politically cripple rival producers Iran and Russia because the governments of these countries that depend on oil exports cannot withstand sustained low prices and will be significantly weakened.
While there may be some truth to both of these theories, the real motivation lies somewhere closer to Sheikh Yamani’s 2000 prediction. Saudi Arabia has embarked on an absolute quest for dominant market share in the global oil market. The near-term cost of grabbing that market share is immense, with the Saudis sacrificing potentially hundreds of billions of dollars if low prices persist. In a world of endless consumption, this risk would be hard to justify merely in exchange for a temporary expansion of global market share – the current lost revenue would take years to recover with a marginally higher share of global supply.
But in a world where a producer sees the end of its market on the horizon, then every barrel sold at a profit is more valuable than a barrel that will never be sold. Current Saudi oil minister Ali al-Naimi had this to say about production cuts in late December: “it is not in the interest of OPEC to cut their production whatever the price is,” adding that even if prices fell to $20 “it is irrelevant.” Implied, if not explicitly stated, is that Saudi Arabia wants its oil out of the ground, regardless of how thin its profit margin per barrel becomes.
Saudi Arabia is seeing a new and massively changing energy landscape. The U.S. and China have agreed to bilateral carbon reduction targets. 2014 is now officially the hottest year recorded in human history, a record set almost impossibly without the presence of El Nino. And on January 7 a report released in Nature lays bare the fossil fuel climate change equation by concluding that to achieve anything better than a 50/50 shot at keeping global warming under 2 degrees centigrade (the most widely accepted threshold for avoiding catastrophic climate change) 82% of fossil reserves must remain in the ground. That report puts hard numbers on the percentages of fossil fuels that must “stay in the ground” and calls for 38% of proven Mideast oil reserves to never to be pumped from the ground. That 38% represents some 260 billion barrels of oil – worth tens of trillions of dollars – much of that not held in Saudi reserves.
All of these threats to oil use are occurring against a backdrop where the acceleration of costs-effective alternative technologies expands the potential of viable alternatives to our current fossil fuel-based energy economy. Yamani’s prediction no longer seems a fantasy where no one outside of science fiction writers could envision an alternative to the age of oil, but rather a stunningly prescient analysis of the future risk to the value the largest oil reserve on the planet by a man who once managed that reserve.
Saudi Arabia no longer needs OPEC. Global action on carbon dioxide emissions is gaining global acceptance and technological advances are creating foreseeable and viable alternatives to the world’s oil dependence. Saudi Arabia has come to the stark realization, as Yamani foretold, that it is a race to produce, regardless of price, so that it will not be leaving its oil in the ground. The Kingdom has effectively open the valve on the carbon asset bubble and jumped to be the first to start the race to the end of the age of hydrocarbons by playing its one great advantage – a cost of production so low that it can sell its crude faster and hoping not to find itself at the end of the age of oil holding vast worthless unburnable reserves.
The end of the age of oil, of course, remains many years off (and almost certainly well beyond Yamani’s timeline of 2030), but to Saudi Arabia, that end is clearly not so far away that the owner of the largest, most accessible crude resource is willing to continue to subsidize higher prices for other producers at the risk of leaving its own oil untapped one day in the future.
Much has been made of the catastrophic economic consequences to Russia, Iran, Venezuela and other oil exporting nations caused by these low oil prices, as well as, the profound damage to their economies and impending political turmoil. Meanwhile in the U.S., there has been endless analysis of the impact (or lack of impact) on the nation’s resurgent oil production and speculation about the price at which U.S. production will begin to decline.
Less well documented is the impact on access to capital for drilling operations (and given the disastrous economics of North American coal, perhaps fossil fuel extraction broadly). Drilling for oil requires huge amounts of capital with a significant appetite for risk, as both production uncertainty and market volatility can undermine the value of investments. In the current production boom, market volatility was wildly underpriced. When combined with pent up appetite for yield due to persistently low interest rates, capital, including tremendous amounts of high-yield debt, has flooded into oil companies. As low crude prices persist there will be substantial losses by investors. This will cause volatility in crude oil markets to be re-priced, and access to low cost capital will disappear for all but a select group of oil production investments.
OPEC will continue to meet and hold itself out as a cartel that can control the oil markets, but that time has passed. The cartel was dependent upon Saudi Arabia to use its outsized swing position to control spare capacity in the market. With the Saudis no longer interested in that role, the influence of the cartel is gone. It would be no surprise at all to see Saudi Arabia actually increase production (though how much additional output is readily available is unclear) as prices stabilize and begin to climb later this year because excess capacity will be shed from the market and global economic growth will accelerate.
The direct oil markets impact and the geopolitical fallout will likely be the defining headlines of 2015, but there is a much much bigger story unfolding: the carbon asset bubble is deflating. The value of effectively every asset class on Earth is influenced by the assumption that a fossil fuel-based economy will persist for so long that any potential for future change to asset values can be ignored. That assumption is wrong. The global industrial economy operates on an assumption of available and relatively inexpensive energy, either in the form of electricity or liquid fuels. If the form, availability of, or cost of, those energy sources changes it will fundamentally change the cost to use and produce virtually every other asset on Earth. And that will necessarily change the value of every one of those assets. There will be both positive and negative impacts, and understanding this change, in both scope and speed, will provide insight on one of the largest wealth shifts ever experienced.
The owner of the most valuable fossil fuel reserve on Earth just started discounting for a future without fossil fuels. While they would never state this reasoning publicly, their actions speak on their behalf. And that changes everything.
Elias Hinckley is a strategic advisor on energy finance and energy policy to investors, energy companies and governments. He is an energy and tax partner with the law firm Sullivan and Worcester where he helps his clients solve the challenges of a changing energy landscape by using his understanding of energy policy, regulation, and markets to quickly and creatively assemble successful energy deals.