In July, Bloomberg News reported that at least 15 percent of the first-quarter revenue for 30 of 62 oil and gas companies in the Bloomberg Intelligence North America Exploration and Production Index came from hedges, derivative contracts that allow producers to lock in prices. In effect, the hedges allow companies to go on receiving a higher than market price for their output. The share of revenue accounted for by hedges is likely to have increased in the following two quarters, as crude became cheaper.
The hedges are a big part of the explanation why U.S. companies have maintained production levels, but most will run out by the end of this year. It's unlikely they will be renewed, because it's too expensive in the current market to fix future prices at up to $90 a barrel, the kind of money frackers are often still paid now thanks to derivatives.
At that point, U.S. drillers will find it difficult to pay back their combined $235 billion of debt. By then, the added technological and financial efficiency unleashed this year will have peaked. New credit will be less readily available and the shale drillers won't be able to repeat their feat from the first half of 2015, when they raised $44 billion through bonds and share sales. Even if their break-even costs are lower than previous estimates, the low crude prices make them look unattractive to lenders and investors.
To predict who is going to gain ground in this drawn-out price war, it's worth assessing the protagonists' arsenals. Apart from $672 billion of international reserves (a cushion that shrank 8.5 percent between January and June), the Saudis still have the devaluation card up their sleeve.
When Kazakhstan belatedly followed Russia in abandoning its dollar peg last week, Prime Minister Karim Massimov predicted that Saudi Arabia and some of its Gulf neighbors would also have to float their currencies to deal with the new reality of crude prices. And the Saudi financial system has other untapped resources: the country doesn't currently even collect income tax; it pays out huge energy subsidies that could be cut; and its government debt is just 1.6 percent of gross domestic product, leaving lots of room to borrow.
King Salman may not want to throw those reserves into a price war with U.S. shale, of course, but he has them. By contrast, all that protects American frackers is their ability to innovate and drive costs down. This year has shown that ability is not to be underestimated, but it is surely finite -- at any rate, U.S. production has stopped growing.
In those circumstances, it's understandable that the Saudis are unwilling to accept defeat. Saudi Arabia won't be satisfied with another temporary rebound in oil prices, such as the one that occurred last spring: Their U.S. competitors would just increase output again. They must inflict permanent damage by demonstrating to investors that with shale, they can't bet on any kind of predictable return. So far, the (probably overblown) threat of Iran's return to global oil markets is helping the Saudis with this task, but it's a long-term gamble and the situation is volatile.
The Saudis may be temporarily thwarted by production decreases in those oil economies unable to hold their corners in the price war, such as Nigeria, where production has been in decline since last fall. Lost production in these countries may send prices up again slightly, giving U.S. frackers a little more breathing space. But until either the U.S. shale industry or Saudi Arabia has triumphed, the onlookers -- even big ones like Russia -- won't be able to benefit from higher oil revenue.