Why the Saudis are Fighting a Losing Battle Over Oil

by | published November 6th, 2014

For the second time in a month, Saudi Arabia has grabbed the headlines in the oil markets. The kingdom is cutting prices again in its global oil feud.

In its latest version, Saudi Aramco (the national oil company) has restored an earlier price cut to Asia, but reduced its price to U.S customers.

That means the Saudis are now trying to fight a crude oil war on three different fronts: against Russia in Asia; with OPEC’s over-producers like Venezuela and Kuwait; and an escalating battle against U.S. unconventional (tight and shale) oil.

But its latest maneuver won’t be enough to turn the tide…

Potshots at Putin Over Asia

First, there’s the kingdom’s tangle with Russia.

The Russian front was the primary reason for an earlier move to slice $1 a barrel off the cost for customers in Asia – which has quickly become the biggest battleground for energy exports.

With the completion of the East Siberia-Pacific Ocean (ESPO) crude oil export pipeline, Moscow is now able to provide crude to Asia that’s better in quality (lower sulfur content) than the Saudi export blend at a lower price.

That move had an almost immediate impact on Russian export prospects, since there is now an alternative market for export that could offset a lowering of trade elsewhere. Russia’s central budget is also dependent upon oil and natural gas exports, and its 2015 budget is already pegged to much higher crude prices than the market is likely to provide.

With ESPO exports now about to move into high gear utilizing a spur to China that’s been underway for several years, it is crucial that the intended benchmark grade (also called ESPO) develop regular initial delivery cycles.

That’s what the Saudis managed to disrupt with their first pricing cut.

With Friends Like These Who Needs Enemies

The kingdom’s contest within OPEC is of a completely different nature.

Within the cartel, a multi-year dynamic continues even as members such as Iran and Venezuela press for a production cut. The truth is OPEC has not directly determined the global price of oil for some time now.

With less than 42% of the world’s daily production, there is simply too much oil on the market not under the cartel’s control. The U.S. and Russia are at top of the list of non-OPEC producers, meaning staggered pricing moves against both are hardly surprising.

Rather, the cartel’s production objectives are met by determining the volume on the supply side. OPEC first determines what the overall global demand will be, then deducts the production from the outside. The result is something referred to as “the call on OPEC,” which is then divided into monthly production quotas for each member.

That has created an ongoing tension inside the organization. The Saudi contest within the cartel has been against members who want to cut production (and thereby increase price), and are actually selling internationally above their determined quotas at the same time.

In this case, there is no stringent enforcement mechanism that compels members to comply with these quotas. That task has fallen onto Saudi Arabia as both the dominant OPEC producer and the world’s primary source of excess export capacity.

Normally, Riyadh balances the performance of others, occasionally cutting its own exports to offset excess sales from other members.

But those days are over. Saudi Arabia is using its clout to undercut the trade evasions of other members. In addition, it also has related supply concerns from other producers. Libyan volume will be moving back into the market after the latest round of domestic fighting there.

Then there’s the production in Iraq and Iran to deal with. Both are OPEC members. But Iraq has been without an official monthly production quota since U.S. military operations began in 2003. And despite its own domestic conflict with the insurgent Islamic State, Baghdad is poised to experience an expanding export flow.

Meanwhile, Tehran has been unable to meet its monthly OPEC export quota for some time, given the Western sanctions. Any breakthrough in negotiations on its nuclear program, however, could ease those sanctions and move a significant amount Iranian crude back into global networks.

Against this backdrop, the Saudis are facing a reduction in their own market share as prices decline. That double whammy is a big blow for an economy that is dependent on importing just about everything besides oil.

A No-Win Situation for the Kingdom

It’s the third front, however, that has developed into their greatest concern.

The U.S. had long been a main end user of imported oil until the rise of the shale age. Only a few years ago, almost 70% of what was needed in the U.S. came from imports. While Canada, Mexico, and even Nigeria (also an OPEC member) would usually provide the American economy with more crude on an average month, it was still the several million barrels a day controlled by Saudi Arabia that was instrumental in setting prices.

These days that flow is down to about 800,000 barrels, with prospects of an even further decline. It’s a direct result of the discovery of huge domestic tight and shale oil deposits in the U.S.

Those discoveries, in turn, have everybody talking about effective U.S. energy independence arriving in the next decade. The U.S. will still need to import about 30% of its daily needs, but virtually all of that will be coming from Canada.

The key to the amount of oil imported and where it comes from is the price. That’s the reason for the latest Saudi move.

By reducing the competitive price for oil, they are also prompting more expensive American unconventional production projects to be delayed or reconsidered entirely.

Ultimately, as with the move last month, the intended target remains American production.

Yet, such an objective is at best an indirect response. It’s currently only a contest over what the domestic mix of oil sourcing is inside the U.S. Washington hasn’t allowed crude oil exports for four decades, although more companies intend to categorize their production in such a way to allow its export now, with Congress likely to open up the export market even further in the near term. There are simply too many jobs and benefits thrown off to local tax bases from the export trade to not allow it.

The Saudis fear rising American competition in global markets is ultimately the real danger to both its pricing structure and its position as the world’s excess producer.

The current Saudi price cut will certainly have some very short-term impact, but ultimately it will not be successful. There are already a number of very inexpensive domestic fields emerging in the U.S. that can undercut any price put on imports.

If the price remains below $85 per barrel (a.k.a. the Saudi “comfort zone”), these efficient, low-cost American wells will simply gain an increasing percentage of the domestic market – not Saudi imports.

In its latest internal strategic plan, OPEC concluded several years ago, that no member would be selling a single barrel of oil to the U.S. by 2050. It’s just happening much faster than they thought, thanks to the new oil sources in the U.S.

It’s a battle the Saudis just can’t win.

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  1. November 6th, 2014 at 16:43 | #1

    Dr. Kent,

    I thoroughly enjoy your analysis of the oil & gas industry.

    What is your “take” on the ban on fracking in some parts of Texas, of all places.

    Please Google:

    “Texas energy group asks court to halt fracking ban” AP Wire By EMILY SCHMALL Nov. 5, 2014 6:39 PM EST. (Your spam filter would not allow me to send to you the link.)

    Again, I am intrigued by your insights and “connections”.


    Bob Duda

  2. Louis L. Boja
    November 7th, 2014 at 01:13 | #2

    Dr. Kent, thank you for your focus on this industry. All of these are looking at the commodity itself–what about the recent developments on the areas of alternative fuel? Electric cars are making a headway and these will ultimately make a lasting effect on the demand on fossil fuel. HHO is competing with these electrics also as an alternative.

    In my country, we are making efforts to go electric. We now have public electric vehicles which will someday ease our imports of fossil fuels. Other Asean countries are doing the same. Environmental concerns also helped trigger our control on the use of the fossils.

    OPEC should be able to determine the right price of their commodity to delay the world’s search for alternative fuel. It has to be very appealing to all users so that they will still use it for, say, another 50 to 100 years. Otherwise, with research for alternative fuel accelerating, demand for fossil fuel will drastically go down fast.


    Louis L. Borja

  3. Louis L. Boja
    November 7th, 2014 at 01:48 | #3

    Dr. Kent, this is what you mentioned in your other article;

    “However, this does point to a major change in the way oil is moving.
    For some time now, OPEC has not attempted to dictate price. That’s
    really beyond its ability, since it controls less than 42% of the
    world’s daily availability.”

    “Rather, each month it calculates the global demand, subtracts
    volume coming from others, and then determines the call on OPEC.
    That ‘call’ is then divided among the various monthly quotas for
    the cartel members.”

    “But in the process, it has lost control over pricing power,
    prompting some to conclude that the Saudi moves will ultimately
    lead to lower prices in the longer term.”

    “So long as the emerging pricing band is stable and in the $85-$95
    a barrel range, the prime beneficiary may still be U.S. domestic

    Saudi’s current price cut is not benefiting them altogether–the prime beneficiary may still be U.S. domestic production. The U.S. is one of their
    competitors and their move benefits the latter. Saudi Arabia should compute for their break-even cost and decide to make a concerted effort to stop competition, head-on. If competition gains ground, then we will say good-bye to the black gold that ONCE dominated world trade.

  4. Jimmy
    November 7th, 2014 at 04:18 | #4

    Dr. Kent

    Just wanted to know what you thought on the new or old as some may call it on the TST3 or some call it Tera Slicing Technology. Is it for real and how fast can it get started to replace Fracking. In Texas this is a big concern because Fracking has really messed up a lot of under ground fresh water supply. The oil industry says this can not happen but the evidence is so over whelming that it does and now I think this new or updated old technology could do the trick, what is your opinion. Thanks for all the hard work that you do.

  5. David Rodriguez
    November 20th, 2014 at 22:24 | #5

    Dr. Kent,
    Have you heard of a technology the uses natural gas at a lower pressure and still gets more volume of natural gas into a tank? I use a dedicated natural gas car (3600 psi)and would like to find out about this technology.

  6. Professor
    March 8th, 2015 at 17:04 | #6

    Dear David. Familiarization with this technology, I suggest you start with the existing patents. After you nothing find, try to find at least one valid document, saying that the company generally has any relation to any technology (except of course the spoken genre). Best regards.

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