Profit as the balance of energy power moves West

Despite the fragile state of the global economy, and growing production in the US, the oil price has remained stubbornly high this year.

The price of a barrel of Brent crude is roughly where it was at the start of the year, at around $110.

Tension in the Middle East over Iran has been one of the biggest issues propping the oil price up.

But a growing number of energy analysts believe that problems in another Middle Eastern country could send the price of crude much higher.

We’re talking about Saudi Arabia – the world’s largest oil producer…

Saudi Arabia’s oil production could be peaking

Earlier this year, amid concerns over Iran’s nuclear ambitions, oil prices started to rise, with Brent hitting over $120 a barrel.

Then the Saudis intervened. Oil minister Ali Naimi publicly pledged to raise production and push down prices. He stated that “Saudi Arabia has invested a great deal to sustain its capacity, and it will use spare production capacity to supply the oil market with any additional required volumes. We have done it many times before, we will do it again.”

Almost immediately, prices started to fall. It also seemed to suggest that the ability of the Saudis to influence the global oil supply was undiminished.

However, a closer look at the figures reveals that it might be tough for them to keep this up in the long term. The problem is that the increase in supply didn’t come from drilling new wells, or even getting a better yield from existing ones.

Instead, it came from bringing wells that the Saudis had previously abandoned back online. These sources have very limited reserves. This means that they are hardly a long-term solution.

Even keeping production at existing levels may be difficult, let alone increasing it. There have been queries about the quality of oil that the Manifa project, due to start pumping in 2014, will produce. And even if it does live up to hopes, the expiry of other wells will mean that overall output remains the same.

There are also big question marks over whether the Saudis are telling the truth about their levels of reserves. Last year, leaked US diplomatic emails suggested that an ex-head of exploration at Saudi Aramco, the state oil company, privately estimated that the country’s reserves are 30% lower than the official figures. He also suggested that “no amount of effort” by the Saudis will be able to stop “a steady decline in output”.

Peaking production is not the only threat to Saudi Arabia’s role as the world’s largest oil producer. The country will increasingly need to keep more of its resources for itself.

According to Citigroup, growth in the population and the economy are drastically increasing energy consumption. If current trends continue, Saudi Arabia will become a net importer of crude by 2030.

Why the Saudis may want a higher oil price

On top of this, Saudi Arabia’s desire to put a cap on prices may also start to weaken. Up until now the Saudis have tried to avoid prices rising too high.

This is not out of charity. It’s because Saudi Arabia doesn’t want to give other countries an incentive to invest in alternative energy sources. There’s no point in killing the goose that lays the golden eggs after all. And the fact that Iran, Riyadh’s main rival, is hit far harder by lower prices is an added bonus.

However, the social upheaval of the Arab Spring and beyond may force Saudi Arabia to change its view. Rulers in Jordan and Kuwait, for example, have tried to buy their rebellious populations off with increased social spending.

While this strategy might work in the short term, it’s very expensive. Jordan already has a large deficit, and the International Monetary Fund has refused to lend them any money that isn’t tied to unpopular reforms, such as the removal of price subsidies. This has forced the Gulf states, including the Saudis, to step in.

Saudi Arabia also has its own problems, with unrest in its eastern province, which follows a different branch of Islam than the rest of the country. There is also growing demand for general political reform in what remains one of the most repressive countries in the world. The frail health of the 87-year old King Abdullah is also another worry. All these factors have led it to increase public spending by $130bn this summer in an attempt to shore up support.

All these spending factors mean that the Saudis may need prices to be at least $90 a barrel to balance the state budget. So at the very least, if prices go up again, Saudi Arabia won’t continue to increase production.

The good news about higher oil prices

This might sound like bad news – and it is in the short run. But in fact, the real bad news would be a prolonged plunge in the oil price. Why? Because that would stifle the search for alternatives.

America’s shale oil reserves could see the US replace Saudi Arabia as the world’s top oil producer by 2020, according to the International Energy Agency. However, because shale oil extraction is a more expensive process, the oil price needs to be around current levels to make it worthwhile.

With Saudi Arabia squeezed by its own budget needs, the chances of it deliberately trying to cut prices to scupper competition in the energy sector, are low. My colleague James McKeigue recently looked at the winners and losers from a US oil shale revolution.

Another exciting alternative energy source is natural gas – press reports even suggest that George Osborne is pinning his hopes for the UK economy’s future on the stuff. My colleague David Stevenson has been looking at the best bets in this sector for readers of his Fleet Street Letter newsletter.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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  • Chester

    The ability of OPEC or the Saudi’s to manipulate the oil price sustainably is questionable. What drives it is speculative money. We heard the peak oil and political influence argument when the oil price spiked to record highs in 2008. The world was comming to an end again. What happened? Liquidity withdrew and prices fell to below $40, irrespective of what Iran or the Saudi’s were doing to themselves

    History is about to repeat itself, although the slump in prices will be significantly more prolonged this time, given the fundamentals

  • colin

    A very good read about the Saudi oil reserves (or lack of) was published in Matt Simmons book “Twilight In The Desert”which was published about four years ago. It really put some serious questions about their oil reserves and ability to increase production.
    Why did the Americans find Iraq so interesting?

  • Roger

    Probably the balance is shifting to US, not Europe, so shift to West is a wrong statement ? The implications for the US could be huge, but not to others.