UPDATE: This article is part of a 5-part series posted in 2016. Latest oil market related article is here: “The coming oil price shock”

So, the question is, why did oil prices suddenly collapse in 2014 and continued slumping into 2016? Neither U.S. fracking boom nor the slow demand growth can explain the event’s timing. We’ve known about fracking since at least 2009 and the “boom” part became quite apparent by 2011. The weakness in global demand wasn’t news either, so what did happen in June 2014 when oil prices collapsed? Supposedly, this had something to do with Saudi Arabia’s refusal to curb excess production for whatever reason – there has been no shortage of explanations. Saudi Arabia is the world’s biggest oil producing powerhouse endowed with virtually inexhaustible reserves of the black gold and the capability to switch the taps on or off and move global oil supply and prices at will. That, at any rate is what the mainstream media narrative would have us believe. However, if we scratch the gloss off that narrative, the situation appears starkly different: Saudi oil reserves may be close to exhaustion and their production may be on the verge of an irreversible decline.

1979: the last independent audit

Here is what we know: the last time Saudi oil reserves were officially audited in accordance with the so-called “Proven Reserves Method” as required by the U.S. Securities and Exchange Commission was in 1979. Based on that audit, Saudi Aramco’s managers reported to US Senate investigators that the kingdom had 110 billion barrels of proven oil reserves, another 67 billion barrels of probable reserves and 69 billion barrels of possible reserves. Oil reserves are classified as proven if there is 90% confidence of them being recoverable with existing technology and under current economic and political conditions. They are probable if there’s a 50% confidence of them being recoverable. For possible reserves, there has to be at least 10% confidence that they can be recovered under existing circumstances and with the currently available technology. In sum, the total of proven, probable and possible reserves in 1979 was estimated at 246 billion barrels.

The magical inexhaustible 260+

In 1980, Saudi oil giant Aramco passed from American management to Saudi Petroleum Ministry control and from that date no further independent audits of Saudi reserves were conducted. By 1987, the “conservative” estimates of Saudi oil reserves increased to 260 billion barrels although no significant new fields were discovered (apart from the relatively small Hawath field, discovered in 1989). This figure – 260 billion barrels has been reported ever since, frozen in time, even though it is highly problematic on at least two counts. First, since 1982 the Saudis have withheld their well data and any detailed information on their reserves so outside experts have had no way to verify Saudi claims. Second, according to the U.S. Energy Information Administration, Saudi Arabia has already extracted close to 105 billion barrels since that last 1979 audit, [i]  implying that its reserves of high-grade, easy to extract oil may be close to running dry!

Confirming the gloom: the Wikileaks revelations

Confidential U.S. Embassy cables from Riyadh released by Wikileaks [ii] largely corroborate the suspicions about Saudi Arabia’s reserves and production. A cable from 2007 recapitulates U.S. Consul General’s meeting with Mr. Sadad al-Husseini, Aramco’s Executive Vice President for Exploration from 1992 to 2004. According to that cable, Mr. Husseini asserted that in 2007, Saudi Arabia had 64 billion – not 260 billion – barrels of remaining oil reserves, that these reserves would last until about 2021 (this is only 5 years from today), after which Saudi output would enter a period of steady decline that no amount of effort could able to stop.

According to the same diplomatic cables, in 2007 Mr. Husseini also pointed out that Saudi Aramco planned to increase production to 12.5 million barrels per day by 2009. In spite of a massive $50 billion investment in expanding production and quintupling the rig count from 15 in the 1990s to 80 in 2015, Aramco never came close to their 12.5 mb/d objective. In fact, in 2009 Saudi output fell to below 8 mb/d and has managed to surpass 10 mb/d only in 2015. All this received further corroboration in a recent report by Citigroup [iii] which concluded that failing to discover major new oil fields, Saudi Arabia might cease to export oil altogether by 2030 – less than 14 years from now!

It’s all down to semantics: reserves vs. resources

Thus, multiple official sources all suggest that Saudi Arabia is facing mounting challenges in maintaining her oil production and that her oil reserves are nearing the point of exhaustion. In the meantime, as nobody in the financial press seems inclined to seriously challenge their claims, Saudi officials made bolder and bolder boasts about the kingdom’s oil wealth. In his 2005 book, “Twilight in the Desert,” Matthew Simmons quotes senior management of Saudi Aramco and Saudi Petroleum Ministry claiming: “we can produce 10 million, 12 million, or 15 million barrels a day for 50 to 100 years. … [To] our 260 billion barrels of proven reserves… we can easily add another 200 billion, and we can still add another 200 billion we have yet to discover.” By 2014, they alleged that the kingdom had 790 billion barrels of oil resource and that this figure should grow to 900 billion Barrels by 2025 [iv].

Such claims should prove confounding to casual observers or even policy makers who give them credence. The financial press doesn’t tend to help matters by habitually loose reporting of facts and even looser use of terminology. For instance, they typically use the terms “reserves” and “resources” interchangeably, as if they referred to the same thing. It is however, critical to discern between the two. The term “resources” comprises oil from contingent and prospective sources including quantities that are potentially recoverable from accumulations that are as of yet undiscovered. Let’s stop and think about that one: oil resources include quantities from as of yet undiscovered deposits!? In other words, we’re analyzing the world’s largest and strategically most significant market based on figures that are by their very definition wide open to exaggeration and wishful thinking. Furthermore, the very term “recoverable,” or “potentially recoverable” is problematic. This is not the same as feasibly or economically recoverable which would imply that the value of extracted oil should cover the costs of exploration, drilling, extraction, transportation and a certain return on invested capital. What we have traditionally understood as “reserves,” usually represents only a small fraction of resources that can be feasibly developed.

Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.

Tomorrow: part 2/5: Oil production and the evolution of drilling technologies. Oil reserves calculus may have changed as drilling technologies improved. Unfortunately, experience hasn’t borne out this optimism…

[i] Saudi Arabia Crude Oil Production by Year: http://www.indexmundi.com/energy.aspx?country=sa&product=oil&graph=production – according to the U.S. Energy Information Administration figures, Saudi Arabia extracted 96.21 billion barrels from 1980 through 2013. At 9.5 million barrels per day, the total through 2014 rises to 99.68 billion barrels of already extracted oil.

[ii] “US embassy cables: is Saudi boom reaching its limits?” The Guardian, 2 February 2011. – http://www.theguardian.com/world/us-embassy-cables-documents/122856 – peaking at these cables is quite interesting; they indicate that one of Saudis’ greatest challenges is attracting bids from any contractors and finding sufficient qualified manpower and engineering talent to develop the new projects needed to maintain oil production.

[iii] Evans-Pritchard, Ambrose: “Saudi oil well dries up.” The Telegraph, 5^th September 2012. – http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100019812/saudi-oil-well-dries-up/

[iv] Reuters (via Gulf Business): “Saudi Aramco’s Oil Resources to Grow to 900 bn Barrels by 2025.” 19 November 2014 http://gulfbusiness.com/2014/11/saudi-aramcos-oil-resources-grow-900bn-barrels-2025/#.VONRFSztCYM