Since the start of 2016, oil prices have swung between $27 and $42 per barrel, about a quarter of the 2008 peak crude oil price of $145. On February 16, oil ministers from Saudi Arabia, Russia, Qatar, and Venezuela agreed to a tentative deal to freeze their production in an attempt to boost prices. This was a characteristic move. For decades, this was how the oil business has worked. Producers carefully control production to try to match supply to demand. But there’s a lag between these decisions and their effects, creating the boom and bust cycles so typical in the oil business.
In reaction to this freeze, oil prices not surprisingly jumped five per cent. But the next day, they promptly fell back below $30. One week later, the oil minister of Iran, a country that had no intentions to join the freeze, and in fact still plans to double its oil production, called the freeze “a joke.”
Nobody really knows what oil prices will be in the future, but countries and companies should prepare for oil to hover around $50 per barrel for the foreseeable future. Historically this wouldn’t be shocking at all. In fact, today’s oil prices that we think of as low are actually near the real average price of a barrel of oil for the last 150 years: $35 (2014 US dollar reference year).
What is surprising though, is the fundamental shift we think is happening. The current low oil price environment is not an “oil bust” that will be followed by an “oil boom” in the near future. Instead, it looks as if we have entered a new normal of lower oil prices that will impact not just oil and gas producers but also every nation, company, and person depending on it. This new normal is the result of the oil business being disrupted.
In the past, it was assumed that conventional oil reserves would be developed by national oil companies and major oil and gas companies to supply virtually all of the world’s oil demand. And it would take them as long as five to 10 years to explore, develop, and then bring production to market after investing billions of dollars into new fields. These are some of the basic assumptions behind the model that has guided the oil and gas industry for decades.
But during the past decade, American shale oil and gas producers pioneered a new business model that shattered the incumbents’ approach. US-based shale oil producers have improved their drilling and fracturing technology, and they can ramp up production in an appraised field in as few as six months at a small fraction of the capital investment required by their conventional rivals.
As a result, shale oil has soared from about 10 per cent of total US crude oil production to about 50 per cent. That has enabled the US oil industry as a whole to produce roughly four million more barrels of crude oil every day than it did in 2008, closing the gap between US oil production and the world’s other two top producing countries, Russia and Saudi Arabia.
In January this year, the US lifted the 40-year-old ban on exporting American oil, and the maiden shipments are finding their way to global markets allowing US oil producers to take advantage of markets that provide higher profit margins.
These “unconventional oil and gas producers” in the US are acting as a quasi swing producer, the counterweight to traditional spare capacity held mostly by OPEC heavyweight Saudi Arabia. At the same time several other countries such as China and Argentina are beginning to develop their shale oil and gas resources by adopting the technology and business model as well as building an investment and supply chain ecosystem that supports this development.
Saudi Arabia, with its excess capacity, used to be a swing producer that could bring production on- or offline to control market prices. But now, that leverage is significantly reduced. If the price goes up, the disruptors can counteract the big producers’ decisions to cut production in a matter of months, rather than years. That’s why the big producers’ decision to freeze production in February, completely predictable according to the old industry business model, was problematic. If traditional producers freeze production and allow prices to go up, shale disruptors will become competitive and simply rush in to fill the void and eat up their market share.
Based on these market dynamics, we have entered a period of sustained low energy prices for the foreseeable future.
Steve Seetahal
Fulbright Scholar in Economics