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.

17 COMMENTS

  1. Never underestimate the other SOBs greed. Iran will break free and start pumping away… The Saudis will not let that stand.

  2. Add also the alternative sources of energy and your post makes an even stronger case.
    The OPEC cartel days of price controls are definitely over.
    It makes me extremely mad that the last oil boom for Venezuela was wasted and stolen by Chavistas.
    I won’t be surprised if the Energy sector comes to a point where is won’t be economically feasible to extract the heavy crude oils from the Orinoco belt.
    In such scenario, Venezuela needs to increase the output at maximum capacity, not curb it while oil is still worth something.

    • The massive underinvestment in oil exploration and development is setting us up for another spike in oil prices, probably around 2020 or a little later. This will be oil’s last Golden Age, let’s hope Venezuela manages to take advantage of this one. Not that it will materially make the country better, as most of it will probably just be used to pay back the debt that Chavistas have accrued.

  3. Short-term, short-covering rally. Good article. Imagine what will happen to oil in the next financial/economic downturn (not too far away, probably)….

  4. Canada, Norway, UK and USA based companies are not members of OPEC… all this will do is embolden oil sales domestically while the prices stabilize again back down to $45/barrel. Enough for a small blip in profits and then settle back down.

    This is, at best, a temporary bit of relief for western oil companies outside of OPEC. Meanwhile, most people filled their tanks yesterday morning and avoided late-day price surges at the pump.

    Thanks!!!

  5. Their cut of production will probably be associated with other geopolitical acts like using the Russian hackers that invaded the voting machines and frauded the US elections to press down remotely the self-destruction button of the shale drilling rigs.

    THAT will put OPEC riding high again! Wait and see.

  6. Old oil hands know one thing : In the oil business the only binding rule is to expect the unexpected ……its been years and years since Opec determined world prices , more important was the inmmense rise in consumption brought about by the economic growth of China , India and other far eastern countries due to globalization ….!!

    What is much less important now is the amount of oil consumed by the US and the EU which has been steadilly falling for a long time now …..(and will continue falling) …..

    Shale oil is certainly a game changer in many ways but there are other factors which can affect the price of crude oil either to raise it or lower it ….!! the introduction of new technology and systems that reduce its use or its production costs , the ennactment of enviromental rules castigating the use of fossil fuels, what happens with coal , what is the fate of globalization !!

    But the biggest booster of shale oil wasnt technology ( much of it was much older than people think) but the fact that world oil prices rose so high that its exploitation became commercially feasible , and easy and cheap credit (which may become less so in the near future) …….!!

    Nothing Opec does now is going to affect prices in the long term , too many variables ( among them shale oil) are likely to surge that change things very quickly and no one can really predict how or when they will appear…!!

  7. None of the OPEC nations can really afford to cut production. Competition outside of OPEC has never been stronger. Saudi is no longer the market maker–except for making oil cheap. Current market forces and growing alternatives make a quick oil recovery seem very unlikely.

  8. Among other things, the cut decided by OPEC revealed the true size of Venezuela’s production. By having to cut 95,000 barrels per day, Venezuela admits its production is only around 2 million barrels per day, instead of the almost 3 million barrels per day the regime has always claimed it produces. This cut will enable U.S. shale oil, as Quico says, to increase their own production and control the initial, psychologically induced rise in oil prices. At such limited rates of variation , 2-3% of the total OPEC production, the “thermostat” effect (oil production decreases, prices increase, production increases, price declines) takes place very quickly.

  9. Venezuela is forgetting that they don’t have any power in OPEC, and that OPEC is going to turn around and bite them.

    Venezuela’s production is falling, and will continue to fall because of lack of investment. That dovetails very nicely with OPEC plans to reduce production. Venezuela “wins” because the price of oil stabilizes or goes up and Venezuela doesn’t have to spend any money on fixing or improving the oil infrastructure. Whoo Hoo! Venezuela is happy as can be. They can continue to steal every dollar of oil revenue to keep their supporters happy.

    But… this puts Venezuela in extreme risk, and at the mercy of OPEC, who can, and will, totally screw Venezuela over when the time is right.

    Wait 12 months. Saudi Arabia is already spending more money than it makes. Iran starts pumping and selling, pissing off KSA. North American shale producers start pumping bringing downward pressure on the prices.

    KSA says “screw it”, and turns on the pumps to (a) bring in needed revenue, (b) hurt Iran. The prices falls through the floor.

    Now Venezuela is in a no win situation. They have no oil infrastructure that can compete, and they aren’t getting the revenue any more. It will turn in to a downward spiral.

    And here is the icing on the cake. Last month Venezuela signed an agreement with India. India will own Venezuela’s oil, what is left of it, so Venezuela can’t get any revenue anyhow.

    The only thing left to do, assuming these idiots are still in charge of Venezuela, is to nationalize the Indian investment and tear up the contract. That will be the death of outside investment and help, and will be be the end of the Venezuela oil industry.

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