This article first appeared in Forum, The Edge Malaysia Weekly, on January 18 - 24, 2015.

Every participant in the oil market knows where the price is heading — down south. But where will the bottom of the barrel be? At below US$30 a barrel, which the market has already tested for international benchmark crudes, oil has slipped into a 12-year low zone.

Analysts from Barclays, Bank of America Merrill Lynch, Societe Generale and Macquarie are all cutting their previous low projections, with many seeing an oil market of between US$20 and US$30, at least until the middle of the year, when demand is expected to increase during the summer months. This will also coincide with the Organization of Petroleum Exporting Countries’ (Opec) meeting on June 2, where it is expected to analyse the demand and supply situation and perhaps cut production.

Some of the “poorer” Opec members, led by Nigeria, want to push for an emergency meeting before that but the big players in the Middle East, led by Saudi Arabia and the Gulf states, are in favour of the status quo for the time being — that is, maintain supply rates even in a glut. Their message to the oversupplied market remains clear: it is unfair to ask Opec to unilaterally cut production while others watch and continue to ramp up production.

While producers and market players continue to test each other’s limits, Standard Chartered is offering a more bearish view: “We think prices could fall as low as US$10 a barrel before most of the money managers [and if I may add, large oil producers like Saudi Arabia, non-Opec Russia and the American shale producers] in the market concede that matters have gone too far.”

US benchmark West Texas Intermediate peaked at US$147 a barrel in July 2008. Opec’s reference price — which comprises the benchmark crudes of its members — averaged US$109.45 a barrel in 2012 and US$105.87 in 2013. It dropped to US$49.49 last year and so far this month, has averaged only US$28.84 a barrel. The drastic drop in price is mainly due to weaker Chinese demand, increased US production and Opec’s decision not to cut output.

And in the commodity market, notably in a situation where there is no buffer stock mechanism, the brutal cure for low prices is … simply low prices. Once the price has reached a level that producers can no longer stomach, they will do what they have got to do to reduce supply and ease the glut.

But the market has yet to reach that situation, at least for Opec linchpin Saudi Arabia, which has often acted as the swing producer and market stabiliser in the past to increase or cut production when the market warranted it.

At the moment, it is not in the mood to do so and lose market share when non-Opec producers like Russia and the American shale oil producers are not talking the same language in controlling production.

Shale oil producers, aided by high oil prices and new fracking technology that made production commercially viable, have been ramping up production since 2009 so much so that they have added four million barrels per day (bpd) to make the US energy dependent and an exporter for the first time in many years. The US has overtaken Russia as the world’s largest oil producer, with production reaching 11 million bpd.

Although Saudi Arabia’s production stands at about 10 million bpd, it is still the world’s largest crude oil exporter, selling about seven million bpd. With 267 billion barrels of proven oil reserves, the second largest in the world after Venezuela (which has 300 billion), it wants to protect its market share.

The Saudis have shown that they are willing to dig in and send the message that market discipline is something that needs to be instilled in all players. This is not the first time Saudi Arabia has abandoned its swing producer role. The last time crude oil dropped below US$10 a barrel was in the mid-1980s when the Saudis flooded the market to teach a lesson to Opec members that cheated on their production quotas and non-Opec producers that did not want to share the burden of easing the glut.

The move worked as members and non-Opec producers came to their senses after prices continued to fall. Opec’s production cut then was supported by some non-Opec producers (including Malaysia) and the market stabilised to a level where it was deemed “remunerative to producers and commensurate to consumers”. At that time, US$25 was a reference price seen as fair to both producers and consumers, and one that encouraged new investments that would ensure future supply.

Being experienced market players, the Saudis and the Gulf producing states (the US shale oil producers believe they can outlast them) share the view of Libyan- born Opec secretary-general Abdullah al-Badri, who reminded the industry: “I have been in the business all my life. I saw six cycles — I saw very high prices, I saw low prices — and this is one of them. This will not continue. In a few months or a year or so, this will change.”

And if the market remains weak for a longer period, the Saudis are showing the world that they are willing to defend their position. They are doing what other producers, including the US shale oil producers, thought they would not do — cutting their lavish budget by announcing a radical austerity programme that includes reducing energy subsidies, which totalled US$107 billion or 13.2% of its GDP.

To increase government revenue, Saudi Arabia is encouraging more private sector participation in the economy and at the same time, selling some assets in government companies. This includes plans to list Aramco, a company Saudi officials say is worth “trillion of dollars” and has oil reserves more than 10 times what ExxonMobil has. As an operator, Aramco also has one of the lowest production costs in the world.

This low price cycle, if it continues longer than anticipated — as has happened sometimes in the past — will result in oil producers and companies drastically cutting capital expenditure. Last year, there was a 23% cut and this year could see another 20%. Spending has dropped from US$673 billion in 2014 to US$444 billion this year.

Such massive cuts in capex, which will certainly affect exploration, development and production of hydrocarbon assets, could leave the world in exactly the opposite position — short of supply as the industry won’t be ready to meet increasing demand immediately even as many buyers are willing to pay more.

Claudio Descalzi, CEO of Italian energy company ENI SpA, said “a big gap is forming in oil industry investment that would lead — in two to three years — to an imbalance between supply and demand that will push prices higher”. And the price recovery this time could be very steep.

The Saudis and the Gulf producers feel the market will go that way and being low-cost producers, they will be the main beneficiaries of a price hike. The American shale oil producers might not necessarily agree with Descalzi’s view and feel that they are resilient enough to continue pumping at their current rates, and can speedily supply the market if and when demand increases.

The crude oil price will recover but before that, will we actually see oil at US$10 a barrel? For an oil-and-gas producing nation like ours, which is now tinkering with its budget, let’s hope not.

Azam Aris is senior managing editor at The Edge

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