What are the all-in costs of Saudi Production?

Here’s an interesting note from UBS’ Andy Lees on the background story to the oil market. You may have heard that US President Obama decided to release some of the oil from the Strategic Petroleum Reserve (SPR). This move was bearish for oil, sending it way down in trading yesterday.

The question then becomes how much of today’s oil price is based on the fundamentals and how much is based on Middle East tensions or speculation.

Andy writes:

A few things to consider on the oil market; 1. Ahead of the OPEC meeting the West had been pushing for Saudi Arabia to pump more oil but it refused saying that there is not the kind of refinery capacity needed to take its heavy crude and that consequently no refineries wanted its oil 2. An oil swap was discussed whereby the US would release strategic reserves and refill their stores with Saudi heavy crude. The deal then morphed into being a swap between IEA reserves and Saudi heavy crude, which appears to be what has indirectly happened. 3. Saudi’s increased production leaves them with just 0.5m bpd of spare capacity leaving the world in a very tight position. 4. OPEC refuses to increase production despite Saudi’s support for such a move indicating that Saudi Arabia may be losing its influence within the cartel. 5. Saudi Arabia has suggested using the oil weapon against Iran by collapsing prices if it continues to develop its nuclear technology. 6. OPEC’s Secretary General said “Strategic reserves should be kept for their purpose and not used as a weapon against OPEC”.

Bloomberg (Deutsche Bank) says that the “breakeven” oil price to fund government budgets this year are USD103bbl in Nigeria, USD96 in Russia the world’s largest crude producer, and USD82bbl for Saudi Arabia. The average for the six nations in the GCC is USD77bbl which rely on oil for 82% of their revenue.The figures do not tally with a report out in November last year in which the Centre for Global Energy Studies said that the needed USD74bbl to balance its budget in 2008 and that in 2009 an overspending of 26% meant that it ran a budget deficit of 6.2% GDP. The Bloomberg article says that Saudi Arabia’s USD130bn of additional spending announced earlier in the year to buy the public support was equivalent to another 23% GDP so clearly that should put the figure somewhat higher than Deutsche suggest without higher volumes of production. Either way the budget deficits infer the all-in political costs of production are not far below spot, however just like we saw in 2008 when commodity prices collapsed, so too did the mines and farmers costs of production as large elements of those costs are other commodities. If food prices fell heavily then the Middle East’s political cost of oil production may also fall.

If you look at this from a macro perspective, the fundamental story supporting commodities comes from growth in emerging markets. And that story remains largely intact.

In May I wrote:

We will have to see where commodity prices go. But clearly, the Obama Administration, now in re-election mode, has a particular incentive to get regulators and exchanges to crack down on speculation in the sector by raising margin requirements. The fundamentals for the developed economies are weak. Austerity is pulling down demand right across Western Europe and I expect the same in the US.

So, you have strong growth in emerging markets offset by weaker growth in the developed economies. Who wins this battle? For now, EM is winning and that is bullish for commodities over the near-term.

That was May 10 after the commodities crash. And commodities did rally for a bit after the crash.

Fine, but soon after that it became clear that the macro environment had shifted. On May 12, I noted that demand destruction had already set in:

My thinking up to now is that the ‘commodities complex’ was largely moving in tandem. But this could be breaking down. All commodities are falling at the moment. However, it is silver’s parabolic run-up and collapse plus oil’s demand destruction which are clearly setting the scene.  When the initial volatility ends, what is the likely path of the commodities complex? If oil doesn’t participate because of demand destruction, how are the ag commodities or metals going to rise when they are dependent on oil?  I think the potential for a divergence in price movement is certainly upon us. But, at the same time, I have a hard time believing that oil won’t drag the rest of the commodities complex down with it.

Oil had to come off the boil in response to a global growth slowdown – and with it the whole commodities complex. (Perhaps the commodities crash was based on the fundamentals?)

On May 18, I wrote:

US interest rates are already at zero percent. QE2 is over and there is immense pressure on the Fed from within as well as politically to refrain from more unconventional policy. My sense is that the economy will weaken significantly before the Fed moves against it – and only then because of vocal outcries for more policy stimulus. At the same time, we should remember, the new fiscal year for states in 2011 and the debt ceiling debates will loom large as fiscal contractions at the same time.

In sum, you have a weakening recovery, uneven job growth, less accommodative monetary policy, tightening fiscal policy at the federal and local levels, austerity in Europe and tightening in emerging markets coupled with secularly high profit margins and above long-term trend price-earnings ratios. In my view, all of this will come to bear in a negative way this summer on risk assets: commodities, equities, and high yield bonds. Treasuries are the mystery. Economic weakness should support them but the debt ceiling debate is an overhang that makes Treasuries unattractive. High quality, high dividend, lower risk equities and high grade corporates outperform in such an environment.

That is what we are now seeing in equities, commodities, high yield, converts and on down the line.

On the oil front, if Andy is right about production costs, it would suggest fundamental support for oil above the $77 level and up to the mid-80s where Saudi Arabia, the swing producer makes money. We’re trading at about $90-91 right now.

However, speculative momentum in these markets has been broken. Emerging market growth is still robust. But unless we see renewed momentum in the global economy, overall, commodities as well as other risk assets are still looking weak.