As fallout over Jamal Khashoggi’s murder continues, the U.S. – Saudi relationship may be facing its toughest test since the 1973 Oil Embargo. The world’s largest crude exporter, and defacto leader of the Organization of Petroleum Exporting Countries (OPEC), is once again threatening to use its vast energy resources as political retribution, alluding to possible price spikes reaching $200 per barrel (bbl) if foreign governments attempt to punish the Saudi regime for Khashoggi’s murder. A Riyadh engineered oil price-spike seems less likely now given the recent downturn in oil prices, but the Kingdom’s influence over energy markets should not be underestimated.

In this ongoing five-part series on the global political and market impact of U.S. shale-derived hydrocarbons, the authors have described the rapid rise of shale, examined global and Asian demand trends for shale-sourced LNG from North America, and studied the prospects for continuing growth in shale extraction in the Trump era. In this fourth article for the series, they survey the varied response of oil and gas producers to the shale phenomenon, focusing particularly on moves by Russia and Saudi Arabia, including some potential areas of convergent interest with U.S. shale producers, but also assessing the OPEC cartel’s direction and divisiveness.

Taken at face value, the specter of retributive pricing complicates an already fraught energy relationship still further; lest we forget, the Kingdom over the past three years initiated and then led a brutal price-war against America’s young shale industry. Yet for all that, the relationship is growing paradoxically both more contentious and more collaborative.

Despite the current diplomatic and PR brouhaha, an emerging convergence of geopolitical and geo-economic interests has become evident. Some industry analysts see the U.S. and the Kingdom – the world’s two largest crude oil producers – more closely aligning their Three ‘P’ (political, pricing and producing) objectives in the coming months and years.

The overlap of mutual interest looks compelling. Both the United States and Saudi Arabia seek to contain Iranian power and fatally damage its regime. Both the US and the Kingdom are protective of their respective oil market share. Both see the best long-term benefit in stable, moderate oil prices. And between August and October of this year, oil prices seemed to be climbing at a dangerous pace – reaching their highest point since 2014.

To achieve the common aim of market stability, both understood that more oil needed to be pumped into the global economy, necessarily exerting downward pressure on oil prices. For the Trump administration, more oil production means cheaper gas at the pump in the run-up and aftermath to the 2020 November elections. For OPEC and its new group of non-member allies – which now includes Russia – moderate prices translate to locked-in demand, preventing consumers from investing in electric vehicles and alternative fuel sources.

More immediately, those with easily exploited spare capacity – the Russians and the Saudis – want more production and more revenue to eclipse competitors. By pumping now, both earn more revenues and protect the long-term sustainability of their petro-economies by increasing supply and keeping prices restrained. Pump too much, however, and fiscal budgets suffer. And as the United States learned the hard way, low oil prices can threaten the survival of a still nascent industry.

What room do US producers have in this calculation? The surprising answer – a Saudi/Russia/US axis in the oil markets.  Here’s why this makes sense:

David vs. Goliath

By the mid-2000s, North American shale producers had emerged as the wild- card disrupter of global oil markets. The combination of lower-up front capital expenditures (capex) and lightning-quick project completion times allowed US drillers to ramp up the amount of shale hydrocarbons extracted at an unprecedented pace. In a blink of a competitive eye, hydraulic fracturing made enormous strata of resource-bearing shale economically exploitable. Suddenly, the world’s top oil consumer could contemplate a very large reduction in its reliance on imported oil.

Foreign producers watched all this very intently. Correctly perceiving a threat to market share, OPEC moved to stifle -- if not strangle outright -- the fledgling U.S. shale industry’s merging impact on the global market. The Saudi-led strategy had a basic simplicity: Flood the world with low-cost crude and push oil prices down, thereby undermining the budding shale industry and prevent the US from recovering its mid-20th century oil market pre-eminence.

But this “drive ‘em to the wall” strategy failed. By this past August, the US reached a daily output of 10.9 million barrels of oil per day (b/d), with unconventional shale responsible for 7.6 million b/d of that supply. The US Energy Information Agency (EIA) estimates that, earlier this year, the United States surpassed both the Russian Federation and the Kingdom of Saudi Arabia to become the world’s largest producer of crude oil.

A rapidly tightening oil market pushed oil prices to a 4-year high, which brought with it talk of $100/barrel once again. This uptick in prices was due in part to collapsing supply from Venezuela and Iran, and from associated geopolitical tensions for both these producers. For the time being it seems that this commodities cycle is winding down, with oil now heading back into the $70 range thanks to slowing global demand – particularly in emerging markets.

OPEC is now feeling global pressure to uphold its mandate of preserving ‘stable markets’ and ‘reasonable prices,’ but the organization seems unwilling and/or unable to do so. Most analysts see OPEC’s so-called “goldilocks” price range as falling between $70 - $90 per barrel. This comes high enough to meet the cartel members’ fiscal breakeven threshold but doesn’t reach price levels which would give decisive impetus to the accelerated development of renewable non-conventional energy sources. We can expect OPEC and its allies to fight to keep prices within this range – a price window that is also amenable to Shale operators, who now enjoy an industry-wide break-even point below $60 per barrel.

As usual, OPEC members quarrel with one another about production levels and price targets. The so-called ‘price-hawks’ (notably Iraq, Iran, and Venezuela) want the 1.8 million b/d production cut to which the cartel agreed back in November 2017. Others, fiscally less desperate, take a market-protection stance, arguing for production increases to prevent a collapse in demand, which would slap down prices again. One thing that all members can agree on, however, is that America’s unconventional producers are encroaching on OPEC market share in Europe and in Asia.

Russia and Saudi Arabia – representing two of the world’s three most prolific energy producers – now face a decision: should they double-down on a cut-price assault on North American shale, or, can they learn to live or even work with this new fixture of the global energy landscape?

The Rebirth of OPEC as ‘OPEC-Plus’

Unlike the 1970s, the OPEC cartel today lacks the raw market-moving power it once had. Its fourteen-member nations nominally control about 35% of global oil output, and claim about four-fifths of all proven reserves.

This arithmetic is now changing, as the cartel pulls in non-OPEC states, including Russia, Kazakhstan, and Mexico. With the addition of seven other non-OPEC nations, the enlarged cartel’s share of global production and reserves now stands at 55 and 90 percent, respectively.

How did this happen? In November 2016, OPEC members joined the most prominent non-OPEC producer states to initial a ‘declaration of cooperation’. The composite group also created an ‘OPEC/Non-OPEC Joint Ministerial Monitoring Committee’ (JMMC).

Superficial analysis sees the resulting OPEC-Plus as new “super cartel.” In reality, however, OPEC-Plus is simply a Saudi-Russian energy alliance, a way for the world’s largest petrostates to bilaterally dictate oil policy while using the new and old cartel members as plausible deniability.

And while Russia and Saudi Arabia share few geostrategic goals, the advantages of a collaborative supply-growth approach over the past 6 months were too many to ignore.

Saudi Arabia: The Kingdom’s greatest geopolitical rival is Iran. With U.S. energy sanctions now back in effect, the regime is facing declining demand for its exports, which have fallen from a high of 2.7 million b/d in April to around 1.7 million b/d this month. By increasing output, the Saudis put a downward pressure on prices and helped to make up for the supply shortfall, thereby depriving the struggling Islamic Republic of much-needed energy revenues (and negotiating power).

Increased production also served to protect Saudi Arabia’s market share from competitors. While market rivals in North America and OPEC-Plus pump at full tilt, the Kingdom possess the largest spare capacity of any oil producing nation (purportedly capable of activating an additional 2 million b/d), meaning that every additional barrel of oil brought online displaces a barrel of competition.

Finally, lower oil prices support the enduring Saudi goal of guaranteeing long-term oil demand. As prices and volatility increase, consumers move to electric and hybrid vehicles, and increase investment in renewable energy sources. A well-stocked global supply of oil defends against fuel switching, thereby prolonging the Kingdom’s economic future. Too far below $70/bbl and we may see the Saudis reverse course – cutting production to maintain the goldilocks price range. But for now increasing production has served them well.