I don’t think so …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).
Here’s why:
Any oil project starts with geology work to locate prospective acreage for drilling. The oil firm then purchases mineral rights from the owner of the land where it intends to drill. Next comes the actual drilling, which can cost $5 million – $10 million a well. The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.
All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.
In other words, the project costs are significantly front-end loaded. This is important. It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.
An example:
I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.
Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion. That’s a net margin of 21.5%. At first blush, it looks like a 20% drop in prices would put EOG in big trouble.
Look at the cash flow statement, however, and a different picture emerges. The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes. So the actual cash that came into EOG’s hands during the period was $3.8 billion. That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.
Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners. But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made. The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.
The wider point: once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out. Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can. It will be willing to destroy the industry pricing structure if necessary to do so.