OPEC’s deal to cut 1.2 million barrels a day’s seen a significant rally in oil prices, with WTI topping $51 a barrel and nearing its yearly. So is this a blip or a game-changer in the oil market? Can this kind of rally be sustained?
Let’s look at it this way. Back in the 1960s, geologists knew there was a whole lot of oil under the North Sea, between Scotland and Norway. It was no secret, but nobody developed it because prices were low: it would just cost too much to get at that oil. So there it sat until the 1973 Oil Embargo sent prices skyrocketing and suddenly those North Sea cost-benefit spreadsheets started to look pretty good.
It took 10 years from the 1973 oil embargo until North Sea oil became a major factor in the market.
Of course, getting oil out of the North Sea was an engineering feat. Massive high tech new ocean rigs had to be designed, built and operated, huge new infrastructure had to be put in place. It took years. But in the 1980s, when North Sea oil started to hit the market in significant quantities, it began to bring down the price of oil, setting off the long slump that brought us, first, the Caracazo and later, the election of Hugo Chávez.
One thing to notice about the story is the lags. They were long. It took 10 years from the 1973 oil embargo until North Sea oil became a major factor in the market. But then a funny thing happened, once prices came down, North Sea oil producers didn’t leave the market.
Why? Because North Sea oil investment was “lumpy.” (That’s a technical term, btw.) It called for big up-front capital investment, but once that first “lump” was in place, running costs weren’t that high. In the economists’ lingo, it had high average costs but low marginal costs…and production decisions track marginal costs.
Fast forward to today’s slump, set off by the new availability of Shale Oil. Just like scientists had known about North Sea oil long before it was economically feasible to produce it, the fact that the rocks under Texas and North Dakota had tons of oil locked up in them has been known to geologists for a long time. There was just no economically feasible way to get it out.
Once again, the oil boom that started in 2003 changed that equation. New technologies came onstream, and with oil in triple-digit territory, it was easy to fund the needed investments.
So far, so 1970s-like. But there’s a difference. Shale oil investment is much less lumpy than North Sea oil investment. You don’t need to spend that much up front, but sustaining production isn’t as cheap. Average costs are relatively lower, and marginal costs are relatively higher. And shale oil production is easier to turn on and off in response to prices. You just stop pumping water into the shale and it stops spewing out oil. Then when conditions are right, you can pick up where you left off.
The adaptability of shale to prices makes a mockery of OPEC’s attempts to control market supply.
The economics of shale just aren’t like the economics of the North Sea. Shale production is much more sensitive to market conditions than North Sea production. When you’re fracking, your marginal cost might be $40/barrel. If oil is at $39.99, you stop the rigs. If it climbs up to $40.01, you fire them back up. Shale is market-responsive in a way non-Opec producers just weren’t in the past.
And that’s a memo that OPEC doesn’t seem to have gotten.
The adaptability of shale to prices makes a mockery of OPEC’s attempts to control market supply. It’s as though OPEC thinks it’s still the 70s and producers are going to take 10 years to bring in new supply to take advantage of higher prices again. That was yesterday’s world.
In today’s world, this week’s oil price leads to production hikes not ten years from now, but next week. Probably some Texas and North Dakota marginal producers who had been sitting out the slump last week are already coming back into the market. In fact, the price slump of the last couple of years has become a driver of competitive pressure, with Shale Producers innovating feverishly to drive down costs:
In shale fields from Texas to North Dakota, production costs have roughly halved since 2014, when Saudi Arabia signaled an output free-for-all in an attempt to drive higher-cost shale producers out of the market.
Rather than killing the U.S. shale industry, the ensuing two-year price war made shale a stronger rival, even in the current low-price environment.
In Dunn County, North Dakota, there are around 2,000 square miles where the cost to produce Bakken shale is $15 a barrel and falling, according to Lynn Helms, head of the state’s Department of Mineral Resources.
“The success in Dunn County has been fantastic,” said Ron Ness, president of the North Dakota Petroleum Council.
Dunn County’s cost is about the same as Iran’s, and a little higher than Iraq’s. Dunn County produces about 200,000 barrels of oil a day, about a fifth of daily production in the state.
It is North Dakota’s sweet spot because it boasts the lowest costs in the state, yet improved technology and drilling techniques have boosted efficiency for the whole state and the entire U.S. oil industry.
The breakeven cost per barrel, on average, to produce Bakken shale at the wellhead has fallen to $29.44 in 2016 from $59.03 in 2014, according to consultancy Rystad Energy. It added that in terms of wellhead prices, Bakken is the most competitive of major U.S. shale plays.
The illusion that OPEC can control supply stably enough to have a lasting effect on prices is a throwback to an earlier era. We’re just so used to a world where that is the case we find it odd to realize that world has passed. In the world of Shale all OPEC can really do is voluntarily surrender market share in return for momentary little price spurts like the ones we’ve seen yesterday and today.
The world changed. OPEC never got the memo.