Saudi Arabia keeps BHP's shale oil in the ground...for now: Column

By Liam Denning on 8/16/2016

NEW YORK (Bloomberg Gadfly) -- Amid the back-and-forth about just what Saudi Arabia is doing in the oil market comes a message from BHP Billiton: Whatever it is, it's working.

As my colleague David Fickling wrote earlier on Tuesday, the Anglo-Australian miner-cum-major is struggling to dig out from the commodities crash. One glaring blemish is its U.S. onshore oil and gas business, where it has spent almost $20 billion to buy its way into the fracing game—and written off more than half of that amount.

So much for the past five years. What's more interesting for the oil market today was what Peter Beaven, BHP's finance chief, had to say in response to a question about spending plans toward the end of Tuesday's call:

I wanted to point out that I think this is one of the strengths of having this petroleum business inside of a broader business, in fact, a shale business inside of a broader business. We have a very, very strong business particularly in the Black Hawk [a field in Texas' Eagle Ford shale basin]. Those returns are available well north of 15% at today's prices given the strength of our position. But on the other hand, we're able to—because we think that oil prices will increase, it's better for us to keep those barrels in the ground and produce them in due course for higher prices and higher returns to shareholders.

Consciously or not, BHP is following Hotelling's Theory here. This is the economic principle that states producers of a finite resource—such as oil—will only sell it today if the price, plus an appropriate discount rate, exceeds what they think it can fetch in the future. In other words, it treats barrels of oil like a share of a company or any other asset: If it's a better bet than other things you could do with the cash today, keep it in the bank (ground); if not, sell it.

What's fascinating about this is that it is the exact opposite of what Saudi Arabia appears to be doing these days—and thereby vindicates that country's approach.

Saudi Arabia hasn't just been ratcheting up production. It is also planning to float Saudi Aramco as part of an ambitious (warning: understatement) plan to diversify its economy away from overwhelming reliance on pumping crude. These aren't the actions of an oil producer convinced that prices can only head up from here.

Part of the reason for this is the shale boom itself. Spencer Dale, BP's chief economist, laid out the reasoning in a speech last year:

In its simplest form, Hotelling does not allow for the possibility of new discoveries of oil or for uncertainty as to how much can be extracted from a particular reservoir. The total stock of recoverable oil resources is assumed to be known and the main focus is on the optimal pace at which these resources should be exhausted. But in practice, estimates of recoverable oil resources are increasing all the time, as new discoveries are made and technology and understanding improves.

If oil isn't, in practical terms, finite—and, in addition, curbs on carbon dioxide emissions threaten to limit demand—then the old wisdom of keeping barrels off the market gets upended.

In maximizing production, of course, Saudi Arabia's actions help make weaker prices a reality in the here and now. And this, in turn, makes BHP wait. That's how a competitive oil market—rather than one controlled by a cartel—operates: Low-cost producers supply first and higher-cost rivals have to wait until demand pushes prices to a level that justifies drilling. As Andrew Mackenzie, BHP's CEO, put it on Tuesday's call:

In shale we have to be responsive to market conditions and produce when we think the prices are high and likely to remain so in order to maximize its longer-term value.

If that sounds like an admission of defeat in the face of Saudi Arabia's onslaught of supply, though, I doubt Riyadh would entirely see it that way.

BHP's experience shows that shale isn't a miracle source of supply where everyone's costs only go down and production only goes up. Equally, though, it is a huge source of reserves that, unlike conventional fields in, say, the deep ocean, can respond reasonably quickly to rising prices—and thereby potentially cap them. In other words, BHP's shale plans show Saudi Arabia is winning the battle, but the war is still very much on.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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