Where oil prices go from here

This article by Dr. Daniel Yergin was originally published in the Wall Street Journal on May 16, 2016.

Leaders of major oil-exporting countries used to talk about "saving the oil" for their grandchildren. But now the grandchildren are in charge, and they want to monetize the oil. That is certainly so in Saudi Arabia, where Deputy Crown Prince Mohammed bin Salman-a grandson of the country's founder, Abdul Aziz ibn Saud-has launched an ambitious plan to reduce the country's dependence on oil. Decrees issued this month announced far-reaching changes in Saudi ministers and government organization.

Yet the result could end up making Saudi Arabia, which now produces one out of eight barrels of the world's crude, an even bigger player in the global oil market. Prince Mohammed's Vision 2030 plan comes as the oil market is working back toward balance, having crashed to a low of $26 a barrel in February from $100 in 2014. Current prices in the mid-to-high $40s are signaling a turn in the market.

And a turn is due. It has been 18 months since the November 2014 meeting when OPEC members made the historic decision to let market forces manage the market-in what became known as a "battle for market share." World production still exceeds consumption. Yet by autumn declining production and rising demand should put the market roughly in balance, with prices around $50 a barrel, although still with a big overhang in oil inventories.

The effect of the oil-price collapse over the past two years can be seen in the postponement, delay or cancellation of multibillion-dollar exploration and production projects around the world. The latest report from my company, IHS, notes that 2015 marked the lowest level of new conventional oil discoveries since 1952.

Even as prices fell during 2015, resilient and ingenious US shale producers dramatically reduced costs and kept increasing output. But now even they have run out of running room. Some have gone bankrupt. For most, survival and protecting their balance sheets has become priority No. 1, and they have slashed investment. So US total production is now falling-by later this year probably by more than a million barrels a day from the 9.7 million peak month of April 2015.

Yet by 2020 world oil consumption could be 5.7 million barrels a day higher than this year's 95.6 million. So prices will have to rebound to provide the signal for new investment. US shale will play an important role because it is "short cycle": New shale production can be brought on much more quickly than multibillion-dollar megaprojects that can require a decade or more.

But a big part of the new demand is likely to be met by Saudi Arabia and other Gulf countries. And here is where the changing stance in Saudi Arabia-the "new new factor" in the oil market-will have a big impact.

Among the decrees this month, Saudi Arabia announced the retirement of petroleum minister Ali al-Naimi, a commanding figure for two decades, and his replacement by the experienced CEO of Saudi Aramco, Khalid al-Falih. In his new job Mr. Falih will be in charge of petroleum and an expanded Ministry of Energy, Industry and Mineral Wealth, as it is thought that the country has significant, largely untapped reserves of minerals ranging from phosphates and uranium to gold.

Continuity is clear in Saudi Arabia's deployment of this new market-forces policy that first emerged at the 2014 OPEC meeting. Prince Mohammed reaffirmed it in April. The oil business, he said, "is a free market that is governed by supply and demand and this is how we deal with the market." The day after his appointment, Mr. Falih stated that Saudi Arabia could well expand output "to its maximum sustainable capacity," from the current 10.2 million barrels a day to more than 12 million, a number that could go higher with new investment.

Moreover, Saudi Arabia doesn't intend to give up one barrel of market share to an Iran that is ramping up its own exports now that economic sanctions have been lifted after the nuclear deal. The heightened tension between the two countries is a central factor in today's oil market.

Yet change is clear in the Saudis' new orientation toward oil. After consolidating most of the Arabian Peninsula in the 1920s into the kingdom of Saudi Arabia, Ibn Saud depended overwhelmingly on rising receipts from the Haj, the annual pilgrimage to Mecca. When the flow of pilgrims collapsed with the Great Depression, so did the country's finances.

The signing of an oil concession in 1933 with Standard Oil of California rescued the kingdom with upfront payments, and it has continued to live off the revenues from oil exports. But that strategy no longer works when 70% of the population is age 30 or younger and unemployment is officially 11.6%, and about 30% among young people.

The new Saudi strategy is to use oil revenues to diversify the economy and build the world's largest sovereign-wealth fund as the investment engine for development. Ninety percent of the government's revenues came from oil between 2010 and 2014; with the fall in oil prices, it is temporarily down to about 80%. The new target is to increase non-oil government revenues at least sixfold by 2030. A key step is the proposed IPO of up to 5% of Saudi Aramco, by far the world's largest oil company.

This shift is also driven by geopolitical forces-the rivalry with Iran, the need to blunt the appeal of jihadists, and the fraying of the Saudi-US alliance. Saudi Arabia intends to bolster its role in the world and make itself a major force in global financial markets. The nation also wants to raise its status as a geopolitical player: As of 2015, Saudi Arabia had the world's third-largest military budget, trailing only the US and China, and ahead of Russia.

Achieving these goals in a traditional society in the designated time frame is challenging. Yet ironically, reducing dependence on oil cannot be achieved without reliable petroleum revenues. This means Saudi Arabia will seek to capitalize on its position as the world's lowest-cost producer to expand output and enhance the competitive position of its oil in what is destined to become an ever-more-competitive global energy market.

Dr. Daniel Yergin is Vice Chairman of IHS, a Pulitzer-Prize winning author and leading authority on energy, international politics and economics.
Posted on May 16, 2016

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.