As a countermeasure against U.S. shale oil producers and financial investors, Saudi Arabia—the world’s largest oil producer—has allowed oil prices to plummet rapidly, driving them down to levels far below the cost of shale oil production.

International oil prices are still moving in a downward channel.

Lower oil prices are good news for consumers and oil-consuming businesses worldwide, but they’re downright disastrous for Russia, Venezuela, and even U.S. shale-oil producers. U.S. shale-oil producers are already on the brink of a crisis. Investment banks are dumping their positions, and the largest-ever private equity deal targeting oil and gas producers has ended in massive losses for KKR.

In the previous round of oil price declines, The Economist conducted a study showing that a $40 drop in crude oil prices effectively shifted $1.3 trillion from producers’ pockets into consumers’ wallets. As a major energy consumer, China—currently in a window of opportunity for reform—could well emerge as a winner from this oil-price war by taking advantage of lower oil prices.

International oil prices continue to show a downward trend.

This time, the price decline has lasted for more than a year. As of 9 p.m. on August 21 this year, the price has fallen to $40.89 per barrel, representing a drop of 64.75%.

On August 21, Kou Jian, a crude oil futures and options trader living overseas, told a reporter from the 21st Century Business Herald in a phone interview in the United States that he has 14 years of experience trading international crude oil futures and options. He expects that, in this round of the oil bear market, prices will continue to fall, and recently he has been consistently taking short positions on crude oil futures and options in line with the prevailing trend.

In this oil-price war博弈, while it’s good news for the side with strong demand, it could spell disaster for U.S. shale oil producers—and even for major oil-producing countries like Russia and Venezuela.

The Game Under Low Oil Prices

Some crude oil-producing countries are currently also seen by certain research and development institutions as strategically shorting crude oil prices.

Shi Fenglei, a senior oil and gas analyst at Argus, believes that “in response to the rise of U.S. shale oil and other non-OPEC oil sources, Saudi Arabia is threatening to abandon its decades-old policy and push these competitors out of markets such as the U.S.: rather than cutting production to support prices, it is allowing prices to fall in order to eliminate higher-cost producers.”

In other words, Saudi Arabia—the world’s largest oil producer—has taken steps to counter U.S. shale oil producers and financial investors by accelerating the decline in oil prices and driving them down to levels significantly below the cost of shale oil production.

Data shows that the breakeven price range for U.S. shale oil ranges from a low of $30 per barrel to over $75 per barrel, with average costs hovering around $60 per barrel. Some large shale oil companies can achieve costs as low as about $48 per barrel.

At 10:00 p.m. on August 21, 2015, the price of crude oil was only $40.89 per barrel.

This is a war of attrition.

Shi Fenglei believes that this strategy is putting the United States to the test: it will have to endure the pain of low oil prices for a longer period than high-cost producers can survive in the market. This battle could last several years, but there are signs that Saudi Arabia is poised to emerge victorious.

The Saudi government relies heavily on revenue from oil exports, which account for 90% of its total income. As a result, low oil prices are severely impacting its budget. Currently, several energy and petrochemical projects in Saudi Arabia have been put on hold because they no longer appear economically viable. Saudi Aramco, the country’s oil giant, has announced that it will postpone some projects and seek to renegotiate certain contracts.

Thomson Reuters, meanwhile, expects Saudi Arabia to likely liquidate tens of billions of dollars in foreign assets—primarily U.S. securities and bank deposits—to fund its strategic initiatives this year. However, these figures suggest that the country has sufficient financial resources to sustain itself for at least several years. The government’s total reserves held at the central bank amount to 241 billion U.S. dollars, while the central bank’s net foreign assets as of November already totaled 732 billion U.S. dollars, including 545 billion U.S. dollars in securities and 131 billion U.S. dollars in overseas bank deposits. This figure does not even account for other assets or the borrowing capacity of a country with extremely low debt levels.

In contrast, U.S. shale gas companies are struggling to survive. Currently, several shale oil companies are on the verge of bankruptcy.

Moreover, Canadian oil-sand producers, North Sea companies, ultra-deepwater operators, heavy-oil proponents, and shale-oil producers outside North America have found themselves caught in a pincer movement: on the one hand, they’re caught in the crossfire between Saudi Arabia and its closest OPEC allies, and on the other hand, they’re also competing with U.S. shale-oil entrepreneurs.

Since international oil prices plummeted by half last summer, Russia—a major oil-producing country—has been facing a less-than-optimistic situation. Oil revenues have long been the lifeblood of Russia’s economy, playing a crucial role in both export earnings and government spending.

Another major oil-producing country, Canada, has been hit hard by the plunge in oil prices, which has led to a reduction in job opportunities and severely strained government finances. This has forced its central bank to cut interest rates, sending shockwaves through the market and seriously impacting the profitability of oil sands projects in Alberta.

Venezuela, a traditional major oil producer, had already been struggling since 2014 due to the sharp drop in oil prices. The economies of OPEC countries are now trying to shake off the weakness caused by falling oil prices; in Venezuela, 96% of its export revenue comes from petroleum.

Therefore, as oil prices began to fall from their high of $90, economists quickly predicted a “perfect storm” for South American countries.

Catalyst for the sharp drop

This oil price war began with... 2014 Year 6 Month.

On June 22, 2014, two oil tankers loaded 1.3 million barrels of crude oil at the port of Tobruk in eastern Libya, marking the end of a decade-long boom in the oil market. Three days earlier, the benchmark Brent crude oil price had surged to a peak of nearly $116 per barrel, reaching its highest level for 2014, before beginning a sustained downward trend.

At the time, few could have anticipated that this price decline would last for more than a year, and as of 9 p.m. on August 21 of this year, prices had fallen to $40.89 per barrel—a drop of 64.75%.

Libya’s ports and oil fields, which had been closed for several months due to unrest, have reopened, marking a turning point in the oil market—and serving as the final straw that broke the back of the oil bulls.

Before Libya’s civil war in 2011, daily oil production was approximately 1.8 million barrels. By April and May 2014, production had plummeted to just 250,000 barrels per day, but by the end of June, it had rebounded to around 600,000 barrels per day. At that time, external forecasts predicted that Libya’s crude oil production would rise to nearly 900,000 barrels per day within the next three months.

By logical deduction, Libya’s oil production stands at only 600,000 barrels per day. At the time, global oil production and consumption totaled roughly 93 million barrels per day. Even if Libya were to resume full-scale oil production, its output would still account for less than 1% of the world’s daily crude oil demand. Thus, Libya’s crude oil output has virtually no impact on the global oil market.

But it ended up becoming the spark that set everything off.

The “explosive barrels” refer to hedge funds and other financial investors. Before oil prices began to plummet, global hedge funds and other financial investors—anticipating further turmoil in Syria—had already accumulated record-long positions in crude-oil-linked futures and options equivalent to 650 million barrels of oil, meaning they had taken bullish positions (indicating an expectation of future price increases and thus buying corresponding commodities or financial derivatives) in order to bet on further price hikes.

This originally seemed like a sure thing: While Libya descended into chaos, Syria was plunged into civil war, and extremist Islamic militants swept through northern Iraq, threatening the country’s oil fields. Fund managers anticipated that oil supplies would further decline, making it virtually certain that crude oil prices would rise—or even surge—without much risk.

However, the Islamic extremist group ISIS failed to capture Iraq’s key oil-producing regions, and the conflict in Libya quickly eased as well, causing oil production to begin rising. This left bullish investors trapped and led to mistakes in the futures market, prompting them to rush to reduce their positions.

By early September 2014, fund managers had significantly reduced their holdings of Brent and WTI-linked derivatives by 60%.

During the large-scale liquidation and settlement process, Brent crude oil prices fell by more than $13 per barrel, a drop of 11%, reaching their lowest level in over a year.

Misfortune never comes alone. Brent crude oil prices fell to $86 per barrel by the end of October, dropped to $70 per barrel by the end of November, and further declined to $57 per barrel by the end of December, before plunging below $47 per barrel on January 13, 2015.

The Suffering from High Oil Prices

What is the real reason behind this sharp drop in crude oil prices? According to Thomson Reuters, the primary factor is that high oil prices have ended up hurting themselves.

From less than $20 per barrel at the end of the 20th century, oil prices surged to $55 per barrel by 2005. In response, alarmed U.S. lawmakers passed the Energy Policy Act. This legislation, which received strong support from both Republicans and Democrats, prompted fuel distributors to begin blending increasingly larger amounts of ethanol into gasoline products.

In 2007, in response to further rising oil prices—reaching around 70 dollars—the U.S. Congress passed the Energy Independence and Security Act, which even more strictly mandated blending targets and raised fuel economy standards for vehicles sold in the United States.

These bills became part of a series of laws and government regulations enacted between 2004 and 2014 in the United States and other developed economies, aimed at promoting energy conservation and reducing demand for increasingly expensive imported oil.

Meanwhile, soaring costs of gasoline, diesel, and aviation fuel are encouraging drivers, truckers, and airlines worldwide to reduce fuel consumption.

The number and mileage of self-driving trips are starting to decline, as consumers opt for smaller, more fuel-efficient vehicles. Freight companies are cutting costs and boosting revenue in their transportation operations, while airlines are streamlining their networks and removing excess weight from aircraft.

In addition, compressed or liquefied natural gas is becoming increasingly popular as a cheaper alternative fuel for buses, garbage trucks, and parts of the freight fleet. Looking back at history, 2005 proved to be the peak year for oil consumption in the United States and other developed economies.

Between 2005 and 2013, U.S. consumption of motor gasoline, diesel, aviation fuel, and other refined products declined by more than 2 million barrels per day—a drop of nearly 12%, even as the U.S. population grew by over 20 million people during the same period and real economic output increased by 10%.

This marks the largest-ever decline in fuel demand and also reflects the current state of the industrialized world. In 2013, fuel consumption in developed economies stood at 8 million barrels per day—lower than the level projected if the growth trend observed in 2005 had continued.

Since 2005, the amount of fuel saved has been equivalent to the total exports of Saudi Arabia, the world’s largest oil exporter.

Demand in the United States, Europe, and Japan has sharply declined, while rapidly growing economies in China, Southeast Asia, Latin America, and the Middle East are seeing increased fuel consumption—but this growth is insufficient to drive oil prices higher. In 2014, Asia also showed signs of slowing consumption growth.

Since 2005, fuel savings driven by the global pressure of high oil prices have already amounted to the entire export volume of Saudi Arabia—the world’s largest oil exporter. This represents a fatal blow to high oil prices.

Another fatal blow was the massive production of shale oil by U.S. shale oil producers—because high oil prices not only dampened demand, but also caused oil prices to quadruple between 2002 and 2012. Coupled with significant improvements in downhole equipment and remote sensing technologies, these factors created the conditions for a second U.S. shale oil revolution—and this time, it hasn't come to a halt.

In 2005, fewer than 150 oil wells were being drilled in North Dakota, USA. By 2010, that number had surged to 850, and by 2013, it had exceeded 2,000. High oil prices became the key catalyst for the U.S. shale oil boom, marking the beginning of the U.S. shale oil revolution and triggering the fastest growth in oil production in history during the period from 2013 to 2014.

As a result, U.S. oil production has surged dramatically. Production rose sharply from 5 million barrels per day in 2008 to 8.5 million barrels per day in 2014, and by early 2015, it had surpassed the 9 million barrels per day mark.

So much excess crude oil—coming from shale and other sources—kept driving oil prices down throughout the final three months of 2014 and into the first few weeks of 2015, even as Libya’s supply experienced yet another disruption.

China's Opportunity

In December 2014, China’s monthly crude oil imports reached 7 million barrels per day for the first time, as the world’s largest energy consumer continued to show its insatiable appetite for oil.

China’s crude oil supply (imports plus domestic production) exceeded domestic refinery demand by nearly 900,000 barrels per day in December, reflecting part of the 90 million-barrel surplus that China accumulated in 2014—most of which will be allocated to strategic reserves.

As a major energy consumer, China has taken advantage of the reform window created by low oil prices to gradually reduce its reliance on coal, lower carbon emissions, and accelerate efforts to upgrade fuel standards and reform the oil and gas sector.

In 2014, China’s economy experienced its slowest annual growth rate since 1990. The International Energy Agency lowered its forecast for China’s oil demand growth in 2014 from 3.6% to 2.7%, and its forecast for 2015 oil demand growth from 4.2% to 2.5%. Supported by the booming car culture, implied demand in 2014 exceeded 10 million barrels per day.

However, diesel demand from industrial users has already declined. According to a public report by Sinopec, its diesel production fell by 4% in 2014, while gasoline production rose by 12.5%. Nevertheless, a roughly 50% increase in the fuel consumption tax is expected to curb demand growth.

It is worth noting that over the past year and more, PetroChina and Sinopec have not been making frequent overseas acquisitions—as they had in previous years—amid the global oil price plunge.

Kou Jian believes that China, as the world’s largest energy consumer, absolutely needs to establish its own energy trading center—settlemented in RMB—for commodities such as oil and crude oil. [Source: 21st Century Business Herald, Author: Cheng Wei]