Saudi Standoff

Daniel Drew,  11/28/2014


Imagine playing a game to see who can hold their breath underwater for the longest amount of time. And the game doesn't end until there is only 1 person still alive. That is what is happening right now in the global oil market.

Yesterday at Vienna, OPEC announced they would not cut production.

The world is awash in oil in a sluggish economy. Every major oil producer is in over their heads. But who can stay submerged the longest without choking on their own oil? Saudi Arabia.

Anyone who tries to call the Saudi bluff will be staring down a royal flush of oil, as the Saudi royal family controls the largest oil producing country in the world. However, the Americans have almost caught up to the Saudis. The Saudis are producing 11.7 million barrels a day, and the Americans are producing 11.1 million barrels. Russian is in 3rd place at 10.4 million barrels.

The United States has only emerged as a dominant player during the last several years, as hydraulic fracturing in the North Dakota Bakken formation led to an oil boom. The Saudis have taken notice of this development, and they are not pleased.

The last time the Saudis put their foot down was in 1986. Oil plunged 67% in 4 months, and oil settled at $10 per barrel. During the most recent rout, oil dropped from about $105 to about $65 so far. That's about a 38% decline in 5 months. That's not as steep as the 1986 decline.

Consumers obviously love this news right now, as gas prices have dropped below $3 per gallon for the first time since 2010. This should increase discretionary spending, which will help retailers just in time for holiday shopping. But this is negative news for the oil companies working in the Bakken fields. They are in the Saudis' direct line of fire.

Eventually, this will be a negative development for consumers. The Saudis will win the price war because they don't rely on hydraulic fracturing, which is a more expensive and difficult extraction process. When the Americans shut down, the Saudis will cut production. With their monopoly reinforced, prices will rise above $100 yet again.

What the Saudis are doing is basically an extended version of the May 6, 2010 Flash Crash, when legit stocks like Procter & Gamble dropped 30% in minutes. Instead of the high frequency traders doing the manipulating, it's the Saudi Royal Family.

The Saudis have 266 billion barrels of reserves and $735 billion of financial reserves. They could flood the market if they really wanted to. Imagine if they unloaded 10 million barrels of those reserves every day in addition to normal production. They can make oil go to $5. The Saudis will do whatever it takes. American oil companies don't stand a chance.

The Chicago Mercantile Exchange has rules for position limits and rules against price manipulation. Those are pretty much irrelevant when one country has 266 billion barrels stashed away. The American Strategic Petroleum Reserve only has 691 million barrels in reserve.

No one can hold their breath like the Saudis.