OPEC and Russia made a massive mistake last November when they decided to try and establish a $50/bbl floor for world oil prices. They ignored 4 absolutely critical facts:

  Major US shale oil producers were already reducing production costs below $10/bbl, as the Pioneer chart confirms
  The US now has more oil reserves than Saudi Arabia or Russia, with “Texas alone holding more than 60bn barrels”
  At $30/bbl, US producers couldn’t raise the capital required to exploit these newly-discovered low-cost reserves
  But at $50/bbl, they could

Former Saudi Oil Minister Ali Naimi understood this very well. He also understood that OPEC producers, therefore, had to focus on market share, not price, as Bloomberg reported:

“Naimi, 79, dominated the debate at OPEC’s November 2014 meeting, according to officials briefed on the closed-door proceedings. He told his OPEC counterparts they should maintain output to protect market share from rising supplies of U.S. shale oil.”

Naimi’s strategy was far-sighted and was working. The key battleground for OPEC was the vast Permian Basin in Texas – its Wolfgang field alone held 20bn barrels of oil, plus gas and NGLs. By January 2016, oil prices had fallen to $30/bbl and the Permian rig count had collapsed, as the second chart confirms:

  Naimi had begun his price war in August 2014, and reinforced it at OPEC’s November 2014 meeting
  Oil companies immediately began to reduce the number of highly productive horizontal rigs in the Permian basin
  The number of rigs peaked at 353 in December 2014 and there were only 116 operating by May 2016

But then Naimi retired a year ago, and with him went his 67 years’ experience of the world’s oil markets. Almost immediately, OPEC and Russian oil producers decided to abandon Naimi’s strategy just as it was delivering its objectives. They thought they could effectively “have their cake and eat it” by ramping up their production to record levels, whilst also taking prices back to $50/bbl via a new alliance with the hedge funds, as Reuters reported:

“OPEC and some of the most important hedge funds active in commodities reached an understanding on oil market rebalancing during informal briefings held in the second half of 2016…. OPEC effectively underwrote the fund managers’ bullish positions by providing the oil market with detail about output levels and public messaging about high levels of compliance”.

This gave the shale producers the window of opportunity they needed. Suddenly, they could hedge their production at a highly profitable $50/bbl – and so they could go to the banks and raise the capital investment that they needed.

As a result, the number of rigs in the Permian Basin has nearly trebled. At 309 last week, the rig count is already very close to the previous peak.

The Permian is an enormous field. Pioneer’s CEO said recently he expects it to rival Ghawar in Saudi Arabia, with the ability to pump 5 million barrels/day. It is also very cheap to operate, once the capital has been invested. And it is now too late for OPEC to do anything to stop its development.

On Thursday, I will look at what will likely happen next to oil prices as the US drilling surge continues.