Declining oil prices: OPEC vs. (future) Shale?
This is not a fight between OPEC and U.S. shale oil. It’s a battle between OPEC and future shale
When the late John D. Rockefeller, one of America’s earliest global business barons, was asked the secret of success, he quipped: “Get up early, work late and strike oil.” Of course, as founder of Standard Oil in the year 1870, he certainly got up early, and worked late as he built an empire of oil that made him the richest man in the world by the early 20th century.
Since then, oil has come to rival water as one of the most essential commodities necessary for modern human life and, thus, the countries and companies that produce, extract, refine, and sell it are among the richest on earth. Rockefeller’s advice still holds.
Norway’s sovereign wealth fund is not far off a trillion dollars and Saudi cash reserves clock in at nearly $800 billion. The world’s leading energy companies report earnings in the billions every quarter.
Partly as a result of the U.S. energy boom, oil prices have hit a five-and-a-half-year lowAfshin Molavi
Thus, it’s no surprise that the current near 50 percent drop in oil prices since June of this year has captured global headlines and spawned numerous narratives: OPEC and/or Saudi Arabia vs U.S. shale oil, one of the more popular ones, and Saudi Arabia/UAE vs Iran/Russia a secondary one. But as with most popular narratives, there is a deeper issue at play here.
First, let us dispense with the Russia/Iran squeeze play story. Theories are rife about a Saudi squeeze play on Iran, a country with far less cash reserves than the UAE, Kuwait, or Saudi Arabia. Iran, the theory goes, will face far more difficulty with the declining oil price than Arab members of OPEC. That’s why Saudi Arabia chose not to “defend” the price through cuts in production, the theory goes.
With a break-even budget price of oil ranging in the $130-$140 range, according to the IMF, a sanctioned Iran with little access to capital markets can hardly handle a sustained oil price decline. Russia, too, faces a tide of rising sanctions and they, too, are hurt by the global decline in prices. By squeezing Russia, the argument goes, Riyadh would be “punishing” Moscow for its support of President Bashar al-Assad.
There may be some truth to this, but to truly do significant damage to Iran or Russia, the price decline would need to be larger and over a longer period of time. With large, fiscal expansionary budgets in Saudi Arabia and the UAE, such a move would risk cutting off the nose to spite the face.
No, there is a larger play here than Iran or Russia. So, is it U.S. shale oil? Is the play to let the price drop squeeze out U.S. shale oil producers who need a higher global price to make their projects sustainable?
Today, the U.S. is producing more oil than it has done in three decades. Over the summer, the U.S. surpassed Russia and Saudi Arabia as the world’s largest oil producer. The U.S. shale boom has added significantly to global inventories of oil and posed a direct challenge to OPEC.
Partly as a result of the U.S. energy boom, oil prices have hit a five-and-a-half-year low, falling by almost 50 percent since June. Brent crude hovers in the $60 range, and U.S West Texas Intermediate has fallen to $57 per barrel. In some parts of the United States, shale oil is being sold for under $40 per barrel.
The key question at play here is this: Is the decline in oil price a cyclical or structural phenomenon? Have the tectonic plates of energy shifted?
To answer that, let us begin with a group of engineers and geologists who, in the early 1980s, began using a technology known as hydraulic fracturing to try to coax gas from tight rock formations in the United States by injecting chemicals and water into the wells. Nothing worked, until a uniquely driven businessman by the name of George Mitchell, laid down the gauntlet for his team of engineers in the early 1980s: get me some shale gas in a decade, or the company collapses.
Mitchell and his team got up early, worked late, and eventually, after seventeen years of trying, they “cracked the code,” as industry observers often say. They became the first company to discover the right combination of water and chemicals to extract so-called tight gas. Those gas fields eventually began producing oil, and today, the shale oil and gas revolution has fueled U.S. economic growth, changed global energy dynamics and transformed global geopolitics.
Radically transforming global energy markets
But will U.S. oil radically transform global energy markets over the next decade or two? The answer is no. Middle East oil, Russian oil and African oil will still be in high demand over the next two decades, according to forecasts by the International Energy Agency. Indeed, most forecasts suggest that by the 2020s, U.S. shale will decline and OPEC oil will be needed to pick up the slack.
So, new U.S. oil will put downward pressure on the price, but will not be a game changer in and of itself. The real question is: Will the U.S. fracking revolution expand globally? If it does, that could have a truly transformational effect on global energy. That would be the game changer.
Imagine a China that fracks. Or an India. Or some of the other large emerging markets that are driving future demand. Or fracking in Europe? In that scenario, we could see both the cost of fracking fall and the world come awash in new supplies of oil, putting tremendous downward pressure on the price, and reordering world energy markets and world power.
Some have suggested that we are still in the early stages of shale oil and gas, something akin to the first clunky computers that hit the shelves in U.S. stores, and were being purchased for office use for the first time. In that pre-Internet, pre-high speed computing era, few could have imagined the growth of the information revolution and how it would transform the world.
The problem with that analogy, however, is that the costs of fracking are so high that only a high oil price environment will allow for companies to take the necessary capital expenditure risks to develop new projects. The declining oil price will not squeeze U.S. shale entirely, but it will make new projects far less feasible. These are not projects that can be hatched in a garage with a couple of engineers and a bit of angel investing money. These are projects that carry massive debt.
In this context, the OPEC decision to let the market find its own price makes sense. After all, a world of Chinese and Indian fracking would pose tremendous challenges to OPEC producers.
So, this is not a fight between OPEC and U.S. shale oil. It’s a battle between OPEC and future shale. Because what is most dangerous to the future of OPEC is not U.S. production, but a world in which China, India and Europe all begin their own fracking revolution.
Afshin Molavi is a senior fellow and director of the Global Emerging and Growth Markets Initiative at the Foreign Policy Institute of the Johns Hopkins University School of Advanced International Studies (SAIS) and a senior research fellow at the New America Foundation, a Washington DC-based think tank. A former Dubai-based correspondent for the Reuters news agency, Molavi has also been based in Riyadh, Jeddah, and Tehran. His articles and essays have been published in the Financial Times, Washington Post, Newsweek, Foreign Policy, and dozens of other publications. He is currently writes a global affairs column for Newsweek Japan.