Download November13th 2014 STRATEGY NOTE WHY A SAUDI PETRO

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November13 2014
STRATEGY NOTE
WHY A SAUDI PETRO PRICE WAR IS BUT A FABLE
“who wishes to fight must first count the cost”
― Sun Tzu, The Art of War
In recent weeks the partnership has found the dominant market meme involving a Saudi Arabian
led OPEC “price war” to be particularly foolish analysis. The story goes something like this:
Saudi holds OPEC production high > Low pricing forces U.S. shale to shut-in > Saudi
gains market share from OPEC partners >Conceivably results greater position with higher
market share in next bull market.
LOGIC HOLES ARE TRI-FOLD

U.S. shale production has no single “shut off price” well breakevens are driven by
productivity and costs. At Eagle Ford a $8mm well with initial production of $400b/d
breaks even at $70/bbl WTI but a $8mm well @ $500b/d breaks even at $55 bbl WTI. As
Ed Morse’s team at Citi highlights in appendix of the note “A 40% reduction in rigs or
more might be needed to completely flatten production growth”Saudi Arabia would
have to “commit” to $50/bbl WTI for a period of time just to fully pause production growth.
Not to mention the sunk cost of rig leases that typically last 18mos and producers will
exclude costs into production decisions potentially lowering “shut-in” by another $10/bbl.

At $65/bbl Brent no OPEC member will be able to run a surplus budget including Oman,
Kuwait, Qatar and the UAE. The Arab Spring of 2011 spread all the way to Riyadh and
scared the kingdom into over $100bb of social spending. The average Saudi man
compares his life to citizens of other gulf states not to those of war torn Syrians and
Libyans. Saudi Arabia’s cost benefit analysis of potential civil unrest or a schism within
OPEC particularly between Gulf state members does not square with the uncertain
benefits of market share gain. The price experience of the 1980’s and 90’s serves as an
example of how prolonged supply gluts can yield the Kingdom a larger piece of a ever
shrinking pie. A Saudi Arabia forced to spend most of it’s current account on social
spending to keep the Shia from “crashing the gates” while simultaneously engaged in a
crude supply war shrinking revenues for uncertain length of time is a recipe for disaster.

Without ability to disrupt US shale “fringe supply” the popular theory is to remove spare
capacity (increase production) and not forgo profits from holding spare capacity.
However, if U.S. shale producers now become the marginal producer and global oil
hegemony is transferred to the US government, how exactly does Saudi Arabia or OPEC
ever get the position back needed to raise prices and reliably meet budgets? At a time of
growing internal resource needs and succession of the royal family to new members
whom had no direct relatives alive at the time of the formation of the country, does the
kingdom really feel the need to gamble with aggressive supply policy?
In our view the market has over hyped a Saudi price war as theme and explanation for
recent price declines that have simply realized the shape of the WTI futures backwardation
that existed earlier in Q2 2014. We are positioning long Brent crude deltas into OPEC’s 11/27
meeting as continuous contract is now down over 27% YTD ( as of 11/14/14)
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