SOURCE: US EIA, Bloomberg, CME Group
That’s the real headline from the geopolitical reaction to falling oil prices. In the past falling world oil prices have provoked a meeting of the OPEC oil ministers who would agree to and announce a cartel cut in production targets to bring down supply levels to match demand. Then the ministers would fly home on their private jets and cheat hoping some other OPEC member would take the production cut medicine so they would not get sick.
Too often that other OPEC member has been Saudi Arabia. It controls the swing productive capacity because it could dial oil production up or down at will. And more often than not it would take the medicine itself—because it was in Saudi Arabia’s best interests —and those of OPEC—to do so. But the other OPEC members didn’t care what Saudi Arabia did as long as it did not affect them.
Why do OPEC Members cheat?
For most of them the answer is what you might expect, they have become accustomed to a certain level of oil income and an oil price above $100 per barrel provided a comfortable living. Meanwhile their domestic consumption costs were going up to satisfy the rising expectations of a growing population for improvements in their standards of living. So when the price of oil drops so does their income, and when the OPEC ministers call for a production cut it compounds the belt tightening.
It’s like cutting your kid’s allowance by 30%—-her reaction? No, fair! Imagine how you’d react to a 30% pay cut all of a sudden.
What’s different this time?
What’s different is the shale revolution in the United States has been an unqualified success dramatically expanding domestic oil and natural gas production. In fact it is one of the few real economic success stories since before the ‘great recession’. Oil and gas production growth in North Dakota of all places has driven down the unemployment rate to less than 4%. Texas is booming as the second largest oil producing state—only Alaska is larger.
Pennsylvania, after being beaten down in the recession and fearing the worst from the Obama Administration’s regulatory pressures on the coal industry. But shale gas production in Pennsylvania grew so much, so fast it became the capital for shale gas production growth in the sprawling Marcellus and Utica shale. Meanwhile next door in New York State a ban on fracking shut down the unconventional E&P growth from shale in that state. So growth moved West to Pennsylvania, Ohio and West Virginia with the same energy renaissance economic growth impacts seen elsewhere.
What about New York? Forgetaboutit!!!! You snooze, you lose in this business!
So much domestic oil and gas production growth has taken place in the United States in the last ten years that oil imports have been reduced to their lowest point in 29 years. And there is no end in sight. The US is poised to become a net exporter of natural gas as LNG and pressure is building to lift the ban on oil exports in the lower 48 states to contend with the supply growth.
For Saudi Arabia, the US shale revolution and the risk that it will spread around the world as US technology and expertise, was too big a risk this time and it decided not to take the medicine. So instead of cutting production on its own knowing its OPEC fellow members were likely to keep producing, Saudi Arabia kept producing and cut prices to good customers in Asia.
Oil on Sale! 30% Off! Get it while it Lasts!
All of a sudden oil was on sale and as prices kept falling over the last quarter the ripple effect of the Saudi decision served notice that the Kingdom was tired of taking the medicine alone. This is an unfamiliar place for OPEC—what do you mean we must do what we said we would do?
Lower oil prices are ruthlessly efficient discipline for many OPEC countries. Russia for years has pegged its natural gas contract prices to world oil prices expecting they would only go up. Now Russia is taking a 30% haircut on its contract prices and finds fewer buyers unless it is willing to lock in today’s low price. Iran has learned how to cheat UN sanctions but they still bite hard when those who buy its oil on the black market down demand an even deeper discount. Venezuela, Nigeria, Argentina the list goes on are countries that have grown accustomed to high (above $100 per barrel) oil prices and now are feeling the pain.
How Long will this Big Sale on Oil Last?
Like all good sales this one too will run its course. The impact of lower oil prices affects producers and buyers differently so the game of chicken and positioning for market share will go on.
- For the super majors and major independents the biggest problem they have is the skyrocketing cost increases for E&P for finding replacement barrels for what they produce. Lower oil prices could slow down or even undermine the economics of some new projects if they persist too long. In the short term they provide an opportunity to renegotiate for price breaks or get better terms from suppliers who now fear the bottom will fall out of their business.
- For national oil companies this is already the nightmare scenario playing out. For many the government sucks as much of the profit out of the business to support their domestic spending or mischief—these governments do not want to hear about less cash flow from their cash cow—so NOCs are more likely than not going to have to keep writing those big checks.
- For the onshore shale players the economics is slightly different but persistently low world oil prices will catch up with them too. The problem for OPEC is by the time the shale producers feel enough low price pain to slow down or stop producing—OPEC may be bleeding out. Why?
Shale producers are winning the market share game of chicken—for now. They are doing it in the cruelest of ways by reducing US oil imports and thus reducing OPEC’s oil market share in the US and its influence. Because the onshore shale producers business model is to attract investors by showing a ramp-up rate in production in the expectation of future profits. Investors don’t all expect to make money today, but build a portfolio of assets across plays to reflect the ramp-up and decline rates common across the shales.
Real supply destruction—the ugliest time in the low price cycle—takes place when investors no longer think they can count on those future profits so they stop investing in unprofitable shale drilling projects today. This is a self-fulfilling prophesy because when one investor drops out from loss of faith the rest of the herd can easily follow. We’re not there yet in the onshore shales so investors will hang on longer. If anything they are betting that OPEC bickering over production levels will be a well deserved humbling experience they’ve had coming to them.
For the US oil and gas markets the bet today is that shale producers will keep on producing because domestic self-sufficiency is a very attractive place to be. Today US natural gas exports in the form of LNG are just ramping up to start in 2017. Other projects are in the pipeline but are not likely affected by a short term low price market—as natural gas markets demonstrated. US oil imports are at a 29 year low so much of the sting of low oil prices is being felt by the sellers. Not even ISIS created oil price spikes. They are not turning the light out at OPEC—but they are not cheering either.