An Oil-Price War´s Surprise Ending -My BPJ article on OPEC, Shale, Trump, Market & Geopolitics

OPEC’s 171st meeting in Vienna on November 30 reflects the new paradigm of the global oil market. After two years, the Saudi-led price war to drive American shale and other “high cost” producers from the market has ended. However, to the surprise of many – not least the Saudis – shale has survived. What now?

The United States Energy Information Agency (EIA) expects persistent market oversupply to have been quenched by the second half of 2017. The Saudis view the diminishing oversupply as an opportunity to cut production by 600,000 or more barrels per day – although about twice this amount would be optimal – boosting prices from under $50 per barrel to $60 or more. The Saudis have worked intensely to reach an agreement at the OPEC summit to coordinate this production cut with Russia; any failure to achieve this highly anticipated deal would sink market confidence, pushing prices into the $30s.

The key obstacle to the Saudi plan is that Iran has refused to participate in any cut, insisting it should first be allowed to re-establish production it lost under years of sanctions. In response, the Saudis have threatened to boost their own production, punishing Iran by collapsing prices and by denying them market share. The Financial Times’ Nick Butler correctly characterizes this as “playing with fire,” and not only because of the severe pain this would impose on weaker OPEC states, but also for the geopolitical retaliation it might provoke from the new US administration as the Saudis would also bankrupt numerous shale producers in the US.

However, even if Russia, Iran, and the rest of OPEC agree to the Saudis’ cuts, US shale is widely expected to expand into the void, re-depressing prices by later next year. In all these scenarios, the future remains extremely difficult for OPEC, for Russia, and for other oil-dependent states.

A Price War Backfires

The prolonged high price of oil, starting to rise in 2002 and then dipping during the financial crisis before rising again till mid-2014, encouraged the emergence of new unconventional shale production. Driven by technical innovations in hydraulic fracturing plus abundant venture capital, by 2014 the US had added more new oil to the global market than what was lost in the Arab Spring and subsequent wars in Libya, Iraq, and Syria. By mid-2014, some two million excess barrels-per-day (bpd) were flowing into storage, and the price collapsed.

(Or, read at Berlin Policy Journal – Free.) Facing unprecedented surplus production, the Saudis insisted that OPEC could not, by itself, cut enough production to boost prices without sacrificing immense market share – which would simply be taken up by relentlessly growing shale production anyway. However, Russia and other non-OPEC producers would not join any cut, while Iran, Iraq, Nigeria, Algeria, and other OPEC members demanded “hardship exemptions.” This led the Saudis to instead push OPEC to maintain production levels to drive prices still further down in an attempt to force what was then seen as intrinsically expensive US fracking out of business. Soon, the Saudis, Iraq, and other OPEC states plus Russia were all increasing production, intensifying their low-price pressure on shale and jockeying for market share before sanctions expired on Iranian production. However, with shale they were chasing a moving target.

How Has Shale Survived?

Fracking was supposed to be expensive, with an initial gush of oil or gas dissipating and soon requiring additional fracking. But all this has now changed.

First, fracking is more like a manufacturing process than conventional oil production. Shale producers were thus able to innovate in technology and operations at phenomenal rates – the Permian Basin in Texas, for example, has shown gains of 500 percent over several years. Horizontal well-drilling was sped up, often by three times, shrinking labor and rig costs. Initial production per new well was also increased substantially.

Second, fracking’s domestic financial backers demonstrated surprising loyalty in spite of high debt and risk levels, reducing bankruptcies below all expectations. And when bankruptcies, mergers, and acquisitions did take place, they generally brought fresh financing, preserved technical capacity, and further rationalized operations, producing more robust firms.

All in all, firms in richer regions remained profitable when oil was in the $40s, and survived losses incurred, especially between November 2015 and April 2016 when prices descended to the mid-$20s. It is important to note that OPEC and Russia require high profits to support their oil-dependent national budgets – generally in the $80s – while private US shale firms demonstrated they can pay loans and thrive with modest profit margins in the $40s. How much lower further tech and operations innovations can take them remains to be seen.

Tech advances recently caused the US Geological Service (USGS) to declare an additional 20 billion barrels of West-Texas Permian Basin oil as recoverable – the largest continuous addition in US history. And, beyond North America, similar deposits in Argentina, China, and Russia could flourish with capital, expertise, and infrastructure.

In short, shale portends a new era of abundant and generally cheap oil and gas likely to last some decades. Of course, major geopolitical disruptions in the Persian Gulf or Russia could resurrect high prices, as the bulk of global conventional oil is produced there. And if global producers continue to under-invest while prices remain low, capacity could be swamped by a demand surge, as came previously from China. However, the resource base is not in doubt, requiring only investment, time, and effort.

Geopolitical Implications

Revenue shortfalls for highly oil-dependent Russia, Saudi Arabia, and Iran bode ill for future relations in the European peripheries of East and Central Europe, the Caspian, and the Mideast and North-African regions. As the three suffer tightening budgets and spend reserves, their room for compromise has diminished.

Energy is already central to Russia’s relations with Ukraine, its now-frenetic diplomacy regarding European and Asian pipelines and other energy deals, and its new Mideast focus. And the conflicts in Syria, Yemen, and Iraq are all cases of intensified armed contention and collusion among these states in parallel with their increasing oil-market competition and policy clashes.

Meanwhile, the US’s expected approach to net-oil-exporter status, based on fracking, could make a jingoist administration overconfident in confronting Iran or the Saudis should the latter undermine US shale producers.

The least volatile geopolitical scenario would be for the Saudis to succeed in cutting production – perhaps by absorbing the bulk of the currently needed cuts themselves, as they have always done before – boosting prices and stabilizing national budgets. Howard Hamm, the fracking billionaire close to Trump, recently told Bloomberg this is the scenario he foresees from OPEC’s Vienna meeting because it is rational. He also “hopes” his fracking colleagues would then react with “discipline” in their own production, maintaining higher prices. This reflects a widely shared view in the US energy business that mutual interests will work to preserve the decades-old US-Saudi oil market (and geopolitical alliance), despite the many other disagreements between Washington and Riyadh. However, in this scenario, it is likely that the US confrontation with Iran would intensify in collaboration with the Kingdom; re-imposing oil-sale sanctions on Iran would certainly make life easier for the Saudis – and all other producers – by reducing stubborn global supply surpluses.

Undermining Energiewende

Finally, there will be significant consequences for climate change mitigation strategies, such as Germany’s Energiewende, which were formulated under very different expectations about remaining oil and gas resources and about the prices renewables would have to compete with. The new hydrocarbon abundance contradicts deeply held beliefs in “peak oil,” the “end of the age of hydrocarbons,” and “perpetually high” oil-and-gas prices – ideas that underpinned more than thirty years of environmental strategy.

Indeed, cheap, abundant, increasingly fracked oil will have complex and destabilizing geopolitical and climate consequences requiring careful analysis – and action.