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Crude Economics
Shale Worries Rise as Oil Prices Fall

It’s a full-on bear market for oil these days, as slowing economies in Europe and Asia reduce demand and new supplies from North America and Libya work to depress prices. Europe’s Brent crude benchmark has fallen more than 23 percent since a peak in June, hitting a four-year low. America’s West Texas Intermediate (WTI) benchmark price has seen a similar decline, down more than 20 percent from its June peak of $107 per barrel, trading below $84 per barrel today. All this has U.S. shale firms acting skittish, as many producers worry that prices will plunge past break-even points (the prices at which drillers can profitably produce) for American shale production. The FT reports:

Wood Mackenzie, the consultancy, estimates the majority of US shale production will break even at $75. The International Energy Agency said on Tuesday steeper drops in the price of oil are needed for US shale and other unconventional energy production to take a meaningful hit. […]

If oil had stayed at $100 per barrel, all of the main shale producers would have been able to cover capital spending from cash flow within two or three years, according to Phani Gadde, analyst at Wood Mackenzie. Below $90, between 30 per cent and 60 per cent of these producers will still be outspending their cash flows.

This price decline means that debts will pile up for the shale industry, but we’re not at a breaking point yet. Thanks to variation between plays, there’s no single price at which fracking would cease to be profitable in the United States, and for now, oil is still trading above threatening levels. In fact, it’s in a kind of sweet spot for America: high enough to keep the shale boom going, but low enough to be a tremendous nuisance for Vladimir Putin, who needs a price above $100 per barrel to balance Russia’s budget, and Iran, which needs a whopping $140 per barrel to stay in the black. That’s not to mention the economic boost Americans get from lower prices at the gas station.

In the meantime, OPEC members are choosing to compete with one another for market share rather than constraining production to boost prices, as they’ve done (or maybe more accurately the Saudis have done) in the past. As the FT notes, this may reflect a new reality in the global oil market brought on by the American shale revolution:

[A] further oil price weakness should prompt a pull back in higher cost production, such as from US shale formations. This, rather than supply cuts from Opec, in particular the cartel’s largest producer Saudi Arabia, would increasingly be the mechanism to balance the market. […]

“Riyadh sees less of a need to act as the swing supplier in a weak market, comforting its geopolitical rivals like Iran and Russia, now that relatively price-responsive US producers have entered the scene,” said Bob McNally, a former White House official and now head of Rapidan Group, a Washington-based consultancy group.

Kuwait, Saudi Arabia, and Iraq have all cut prices recently in a bid to secure a larger market share in the midst of crude’s big plunge, much to the chagrin of the petrostates that require a higher breakeven price, like Venezuela, whose cries for an emergency OPEC meeting have gone unheeded.

Instead, it looks like we’re left to wait for OPEC’s next meeting in late November to see whether or not the cartel’s members will band together to stop the price slide. For now, we’re left with a return to volatility in the global oil market after a period of relative calm, and America seems to be benefiting in some important ways.

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  • Kevin

    I think the US ought to put in place a variable protective tariff on oil, something like 3/4 of the difference between the spot price and $100 per barrel.

    This would provide price stability for domestic producers and prevent them from being run out of business by swings in price. Such a tariff would also modestly reduce the world price of oil (by reducing US demand for it to the extent the price dropped be the floor) and potentially deprive hostile regimes of some of their revenue.

    Any revenue collected could be returned to taxpayers by a dollar for dollar offsetting reduction in payroll taxes to maintain aggregate demand and prevent it from being a regressive tax.

    Even if the floor (say $100) was never breached after the variable tarrif policy was implemented, it’s mere existence would make it easier for drilling firms to raise capital by reducing threats of extreme pricing volatility.

    Oil prices are in large part determined by political factors rather than purely economic factors. To let American oil producers be driven out of business by relatively short term swings in international pricing driven by foreign governments seems foolish.

  • Jacksonian_Libertarian

    I’ll put my money on the American shale oil companies as being better able to compete over the state owned oil monopolies any day. Most of these state owned oil monopolies are operating their entire governments from the profits on oil, when these go down they will suffer drastically. Sure some like Saudi Arabia have low costs of production, but they are also paying billions to Egypt and welfare programs and the Royal family of thousands, in addition to all the state functions. These things will all face cuts before American shale oil companies have to take serious cost cutting measures. Also American shale oil companies already have structures in place to improve well production and cut costs, something the stagnating and decaying state owned oil monopolies don’t have. Recent graphs on this blog show the skyrocketing increases in well production and there is every reason to believe this will continue until the increases begin to slow.

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