Saudi Arabia expects oil prices to stabilize around $60 a barrel, according to the Wall Street Journal, a level both it and other Gulf producers believe they could withstand. While word of oil prices dropping even further is not being heralded as good news in industry circles, there may be an end in sight to the massive slide in oil prices that occurred in the second half of 2014.

$70 Saudi Oil

When Saudi Arabia trimmed its prices to $71 per barrel last month, markets believed $70 per barrel might be the base price for oil. But after OPEC’s Thanksgiving Day meeting, in which the cartel decided to maintain production at current levels, oil prices took another big tumble.

At the time of this story, Brent was sitting at $69.14 a barrel, presenting the Saudis with a $9 cushion between here and $60.chart (7)

Instead of cutting production to bring prices back up, experts have postulated that the Saudis are hoping that lower prices will make U.S. shale producers feel the economic squeeze, and force them to slow down development or stop drilling altogether.  The tactic the Saudis seem to be employing now is to let the price fall far enough to put the higher-cost shale producers out of business—the price war theory.

Forcing some of the shale producers out of the industry would lower global production without the Saudis being forced to give up their portion of the market. “Since shale-oil wells are short-lived (output can fall by 60%-70% in the first year) any slowdown in investment will quickly translate into falling production,” says the Economist. As a drop in shale production takes supply off the market, the global oversupply situation starts to dry up, leading to a balanced equation or demand overtaking supply.

Reasons Why the Saudis Won’t let Oil Prices Fall Much Further

The Saudis do not need to worry about the price slump nearly as much as shale producers do, but they should still be mindful, says Meghan O’Sullivan, a professor of the practice of international affairs at Harvard’s Kennedy School.

“Saudi Arabia is comfortable with the current slump,” said O’Sullivan. “It is in a strong economic position: Its reserves are close to $750 billion and its national debt is practically non-existent. [But the Kingdom’s] budget is laden with big infrastructure projects, but many could be cut if necessary. The kingdom can weather low prices so as to protect its market share and wait for new market dynamics to settle out.”

Despite its economic breathing room, O’Sullivan says there are reasons for the kingdom to keep prices from falling much further, though. “Will the Saudis be content to let the price of oil free-fall if supply-and-demand fundamentals continue to push it significantly downward? Probably not. While the Saudi economic cushion gives the kingdom tremendous economic leeway, there are political considerations that could make the government nervous about even-lower prices,” she said.

The Saudi royal family in Riyadh has more than just their business financial break-even point (most estimates put it at less than $10 per barrel) to consider while they watch the price of oil continue to drop. “Riyadh has to be sensitive to how its own citizens perceive lower oil prices,” O’Sullivan says.

“Even if the nation can weather the economic fallout, falling prices could translate into a perception among the Saudi people that the monarchy has lost control of the oil market, and inject greater instability into an already uncertain domestic political environment,” according to O’Sullivan.chart (3)

The Gulf states “don’t have a price target, and if prices drop further below $60, it won’t be for a long time,” a Gulf oil official told The Wall Street Journal.

Even as the tremendously low financial break-even point for Saudi oil gives the kingdom room to let prices drop, they cannot ignore the “social break-even” required to maintain political stability. “The monarchies of the gulf have been fortunate in staving off the political revolutions that upended the neighboring Arab republics – in large part by increasing public spending in a big way,” says O’Sullivan. In other words the subsidized citizenry might not be very pleased if the royal family starts taking things away due to lower revenues coming in from selling a lot less oil at a low price.

The royal family now has to consider the cost of the social contract it has with its citizens when pricing every barrel. Letting prices drop further might be economically viable, but the political consequences could be worse for the royal family than letting U.S. producers have a piece of the pie—a new phenomenon affecting the global equation.

Stronger U.S. Shale Producerschart (6)

While falling prices continue to cause concern within the industry, there is light at the end of the tunnel. Shale producers that are able to come through this period of low prices will have greater volumes of resources to exploit, all well the fledgling technology behind the shale revolution continues to improve. Already, the research firm IHS estimates that the cost of a typical shale project has fallen from $70 per barrel to $57 in the last year alone, reports The Economist.

As Saudi Arabia seeks to find a bottom that won’t lead to political instability, ingenuity of U.S. shale producers will continue to bring on more efficient ways to drill and produce, lowering their own costs. Low oil prices might push some out of the industry, but with larger margins expected as technology improves, temporarily low oil prices could convert U.S. shale producers into much stronger players in the global market.

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