On Friday, on the way to diving into Goldman’s $20 crude call, we recapped our characterization of low crude prices as a battle between the Fed and the Saudis, a battle which is now manifesting itself in budget troubles in Riyadh and a concurrent FX reserve burn. Here’s what we said:

 

 

When Saudi Arabia killed the petrodollar late last year in a bid to bankrupt the US shale space and secure a bit of leverage over the Russians, the kingdom may or may not have fully understood the power of ZIRP and the implications that power had for struggling US producers. Thanks to the fact that ultra accommodative Fed policy has left capital markets wide open, the US shale space has managed to stay in business far longer than would otherwise have been possible in the face of slumping crude. That’s bad news for the Saudis who, after burning through tens of billions in FX reserves to help plug a yawning budget gap, have now resorted to tapping the very same accommodative debt markets that are keeping their competition in business as a fiscal deficit on the order of 20% of GDP looms large.

Still, as we went on to point out, it looks like the Saudis have dug in for the long haul here and the strain on non-OPEC production is starting to show as the IEA now says “the latest tumble in the price of oil is expected to cut non-OPEC supply in 2016 by nearly 0.5 million barrels per day (mb/d) – the biggest decline in more than two decades, as lower output in the United States, Russia and North Sea is expected to drop overall non-OPEC production to 57.7 mb/d.” 

“US light tight oil, the driver of US growth, is forecast to shrink by 0.4 mb/d next year,” the agency adds.

Still, the Saudis know that the war is still far from won, which again is why the kingdom is now borrowing to supplement the use of their petrodollar reserves. But as we’ve documented in great detail, the Saudis face a unique set of challenges when it comes to managing fiscal spending. The cost of maintaining the average Saudi’s lifestyle as well as the cost of financing one (and soon two) proxy wars translates to a tremendous amount of budget pressure. Add in defending the riyal peg and you have yourself a problem. So even as the Saudis have ample room to borrow (debt-to-GDP is negligible at present), Riyadh would rather US production fold sooner rather than later and with the next round of revolver raids coming up in October, and with the bond market set to cast a wary eye towards HY going forward, the kingdom just might get its wish. Citi has more on shale’s “dirty little secret”:

 

 

Easy access to capital was the essential “fuel” of the shale revolution. But too much capital led to too much oil production, and prices crashed. The growth of North American shale a critical underlying factor in the oil market “regime change” from a $100/bbl world until 2014 to a sub-$50/bbl world today (see Oil and Trouble Ahead in 2015 ). Saudi Arabia’s shift to defending market share rather than price decisively confirmed this new reality. Above $100/bbl, returns to shale investment are so attractive that the kingdom realized it could not sustain its historical strategy of propping up prices or shale would simply erode its market share. As a result, the oil markets returned to competitive economics not seen for decades. And the economics of shale in particular are now set to be a decisive factor in balancing global oil markets and setting global prices.

 

The shale sector is now being financially stress-tested, exposing shale’s dirty secret: many shale producers depend on capital market injections to fund ongoing activity because they have thus far greatly outspent cash flow. In the aggregate North American crude producers do not generate positive free cash flow (Figure 1), although some stronger producers do.

 

Capex has consistently exceeded cash flow, causing some prominent critics to argue the business model of shale production is fundamentally unsustainable.

 

 

Capital markets plugged shale’s “funding gap” from 2009 through the first half of 2015, but they are now tightening, reducing access to liquidity for some producers and shaping their ability to drill. With eight bankruptcies already announced this year, weaker producers may live or die by the whims of capital providers. The sector is by no means homogenous, but those producers with poor asset quality, high leverage, little hedging protection, and/or dwindling free cash flow look most exposed.

 

 

If OPEC traditionally set the marginal supply and served as a coordinated price setting mechanism, capital markets are becoming a new balancing mechanism: a set of highly dynamic, diffuse investment decisions that shape shale production and a large portion of the global marginal supply. Shale oil financing and production is different from what the oil market had become accustomed to over the past few decades. In particular, shale 1) is produced by many smaller, innovative producers who depend on capital markets for financing; 2) is a faster drilling process with smaller, more discrete investment decisions that respond more quickly to market conditions. These factors accelerate the classic commodity cycle of high prices leading to over-investment, which crashes prices, then leading to underinvestment, which raises prices, starting the cycle again. 

 

So what’s the endgame, you ask? According to Citi, “two things become clear in an analysis of the financial health of US hydrocarbon production: 1) the sector is not at all homogenous, exhibiting a range of financial health; 2) some of the sector indeed looks exposed to distress [and] lifelines for distressed producers could include public equity markets, asset sales, private equity, or consolidation. If all else fails, Chapter 11 may be necessary.” 

Got it. So essentially, with HY all but closed, banks re-evaluating credit lines, and the cost of funding set to rise, there are essentially only three options: liquidation of assets, tap the dumbest of the dumb money by selling more shares, or else throw in the towel. 

Of course there’s another possibility: oil prices rise sharply. And while everyone seems to think that’s highly unlikely, the irony of ironies here is that if Saudi Arabia continues to beat the war drums in Yemen and Syria, Riyadh could end up being shale’s savior.