The oil price war is set to get vicious

By John Stepek

published 14 July 2015

in Features

150714-oil-well — There's likely to be a lot more volatility in the oil market yet

Here's an interesting statistic:Saudi Arabia is pumping more crude oil than ever before.

In June, it produced 10.6 million barrels a day. That's the highest on record, and up 200,000 barrels a day on May.

Why is it pumping out oil like there's no tomorrow?

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Why Saudi Arabia is pumping oil like mad

Oil cartel Opec got used to the feeling of having the world in the palm of its hands over the past decade or so. Oil prices soared. Everyone said that $100 a barrel was the new norm. It'd never get cheaper than that again. We'd just have to suck it up.

The thing is, high oil prices made it worth everyone's while to start looking for other sources of the stuff. And that's when fracking' really took off in the US.

At first, everyone dismissed it as overhyped. Then, as the natural gas flowed freely, the argument was that fracking might work for gas, but it wouldn't change the oil market.

Of course, it did. US crude oil output is now up to around 9.7 million barrels a day, according to the US Energy Information Administration.

It's hard to emphasise how astonishing this is. If someone had told you in 2000 that the US was less than two decades away from being as big an oil producer as Saudi Arabia, you'd have laughed them out of town.

(It's events like this that make me take the secular stagnation' argument with a hefty pinch of salt. Secular stagnation is just the latest new paradigm' view designed to justify our odd financial environment. It also provides intellectual cover for central banks to go on experimenting with monetary policy.)

Anyway, getting back to the point in hand. I've mentioned this before, but think of this being like supermarket price wars.

If you own a big shop, earning decent profit margins from a captive audience, and a smaller rival opens up and starts to undercut you, what do you do? Do you keep your own prices high, and let him continue to steal market share?

No chance. You slash prices as low as possible, sit back on your copious cash reserves, and wait for the other guy to go out of business.

That's what Saudi Arabia's doing. It doesn't cost much for it to increase production, so it pumps more oil. The oil price crashes, and US oil producers who require higher prices either stop drilling or go out of business.

There's also the small matter of Iran re-entering the oil market now that a deal seems to have been agreed to relax sanctions. As David Sheppard puts it in the FT, Saudi Arabia "is unlikely to want to cede market share or see its regional rival enjoy a higher price."

Cheap oil versus cheap money

You see, the Saudis reckoned without cheap money. Quantitative easing has in effect, left investors with no sense of risk. Shale oil producers should have been going bust left, right and centre. Instead investors have been snapping up their moderately higher-yielding debt and cheerfully rolling it over.

Meanwhile, the oil price has rallied to levels that might prevent US producers from giving up the ghost. Particularly as the technology behind fracking keeps improving, too.

This is probably yet another case of can-kicking'. Credit rating agency Moody's remains worried about shale oil companies, and it's hard to believe that we won't see a blow-up in the sector at some point.

And it's pretty clear that Saudi Arabia is settling in for the long run. The country borrowed $4bn on the bond markets this week, selling bonds for the first time in eight years.

High oil prices and a desire to avoid being caught up in the Arab spring' have inflated public spending hugely. That was fine when oil was at $105 a barrel, but not so much now. Rather than cut back, Saudi Arabia is borrowing to make up the difference.

So with everyone still fighting for market share and survival, and plenty of cheap money still going round, we might yet see more volatility in the oil market before one of the participants gives up.

What does all this mean for oil groups? Prices have fallen gradually in the sector. And chances are, it means that more of them are going to be vulnerable to takeovers. According to Bloomberg, "Big oil deals are ready for an explosion". In North America at least, you can now buy barrels in the ground reserves more cheaply than "at any time in the last ten years".

Meanwhile, the gap between analysts' estimates of what companies are worth, and their actual value as measured by market capitalisation, is narrowing. That's often a sign that deals are about to pick up, reports the newswire. In short, oil producers are starting to look cheap enough to get buyers interested.

You still have to be careful, but my colleague Matthew Partridge looked at one company likely to benefit in the latest issue of MoneyWeek magazine. You can get your first four issues free here.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.