End of the Oil Age?

Briton Ryle

Posted May 9, 2016

Ali Al-Naimi once said, “The Stone Age didn’t end for a lack of stones.” 

If you don’t know, Ali Al-Naimi has been the Saudi Arabian oil minister for 21 years. He stepped down over the weekend. It’s not clear whether he left his post voluntarily, or whether the youth movement behind the Saudi throne pushed him out. And I guess it really doesn’t matter much why…

Just the simple fact that Al-Naimi, who increased Saudi oil production by 2 million barrels a day in order to crush oil prices and drive the so-called “marginal producer” out of business, is gone is very significant for oil prices. 

There should be no doubt that Saudi Arabia is paying a hefty price for its strategy. The kingdom has lost well over $300 billion in oil revenue over the last couple of years, and they’ve spent another $300 billion out of their foreign reserves.

It seems pretty dumb to sell your oil for $40 a barrel today, when just two years ago you could get $100 a barrel for it. Especially when you have a government budget that is predicated on $100 oil, like the Saudis do. But the Saudis are looking ahead to the end of the oil age. And just like with the Stone Age, the end of the oil age will not come about because of a lack of oil. 

Can’t See the Future

It’s part of the human condition that we can’t really see the future. Even against all evidence, we have a hard time imagining the fundamental change that we will certainly face in the future. Can you really imagine a time when robots are doing the jobs that millions of us do right now? Or when driverless cars dominate the roadways? 

It won’t be long before major shipping routes cross the Arctic because there isn’t any ice there anymore. Alaska will one day be a critical port for global shipping. But are we planning now for that inevitability? 

It’s the same with energy. It’s all well and good to install solar and wind and use less coal. But are we really looking ahead to a time when renewables rule and fossil fuels are barely used? It’s pretty much inconceivable…

But that’s what the Saudis are looking ahead to. Why else do you think they are looking to raise a couple trillion dollars by selling off some of their state oil company, Aramco? They are well aware that oil’s days are numbered.

So what do you do if you know that your main product is on its way out, that you maybe have 20 years left? You might think that, yes, keeping the price high in order to make as much cash as you can in the time you have left would be a good idea. But that ignores the lesson that Saudi Arabia got back in the early 1980s…

Oil was trading for $35 a barrel back in 1980, capping a remarkable run from $3 a barrel eight years earlier. OPEC had been fixing oil prices to higher and higher levels. And the strategy seemed to be working pretty well — they were making a lot of money with 10.3 million barrels of daily production. OPEC was seen as very powerful. 

But high prices can have a strange effect. Oil consumption in the U.S., Europe, and Japan fell by 13% between 1979 and 1981. Also, because prices were high, exploration was intense. Oil started flowing out of Alaska in 1977. Mexico’s Cantarell Field was pumping 1.1 million barrels a day in 1981, just five years after it was discovered. Huge discoveries in the North Sea in the late 1970s boosted non-OPEC production, too…

Saudi Arabia and OPEC made the predictable move to cut production in order to keep prices high. It was too late. By 1985, Saudi production had fallen to just 3.6 million barrels from 10.3 million barrels in 1980. But prices still collapsed from $35 to a low of $7.90 a barrel. 

Kill the Competition

It’s pretty easy to see how high oil prices spurred U.S. shale oil production to record highs. When oil is $100 and you can produce it for $60, well, you can make money even if other producers like Saudi Arabia have significantly lower costs. 

It is against this backdrop that the Saudis decided to increase production. It really is the only move that makes sense. If they cut and keep prices higher, more U.S. oil will come on line. The only move that makes sense for the Saudis is to actively push prices lower, drive companies out of business, and force their oil off the market. They will not stop until they have killed the competition. 

And that brings up another interesting angle to this: High oil prices have also pushed the development of renewables like solar and wind. But what if the Saudis can even prolong the oil age by making it irresistibly cheap? 

So when the oil age ends, the Saudis want to make sure it won’t be for a lack of U.S. oil. They want to make sure we still have plenty of uneconomical oil in the ground when real oil demand starts to fall…

Now, it takes a couple years for supply imbalances to work themselves out in the oil markets. Even though there was an oil glut in 1980, prices didn’t really start to collapse until 1983, when they fell below $30. And this time around, the oil market was oversupplied for at least a year before prices started to fall.

The next move is predictable. U.S. oil production will continue to fall. Prices will start to rise. And don’t be surprised if the Saudis even announce production cuts. But the minute it looks like U.S. production will ramp back up, the Saudis will pump like there’s tomorrow. 

This game is far from over. And it’s not looking good for U.S. shale companies.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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