Oil wars: Peace at what price?

Houston Chronicle • December 31, 2014 • by Dr. Nansen G. Saleri

OPEC's decision not to scale back its crude production triggered an epic earthquake in the oil markets. Some claim that this is a knock-out punch to American producers with a corollary message to dissidents within and beyond OPEC - namely Iran, Venezuela and Russia. In a supply-dominant energy era, OPEC and American shale producers are fiercely juggling to define the new "normal" in benchmark crude prices. The first round went to OPEC as prices plunged below $60, but the rounds ahead will decide if $60 is a floor, ceiling or none of the above.

The root cause of the price collapse was the ballooning of global crude and gas spare capacity and alternatives spurred by the shale revolution. Worldwide crude supplies grew approximately 1.6 million barrels per day in 2014, 90 percent of which came from the U.S. The break-even prices for US shale oil, i.e., lifting costs, range from $50 to $90 per barrel. Thus, one could expect a noticeable drop in U.S. shale output at prices below $60. How much and how fast are two important questions. Unlike conventional wells, shale producers typically deplete at annualized rates of 50 percent to 90 percent per annum. Completely choking off expenditures on drilling and fracking - an extreme scenario - could yield a 50 percent drop in as little as 6 months. The wild card, however, is the relentless force of new technologies and learnings. Tomorrow's break-even prices in shale production could be half of what they are today - hence the dilemma faced by OPEC in pushing the prices down. As the saying goes, "Be careful what you wish for": $50 oil may in fact unleash a new wave of innovation among shale producers forced into a battle for survival.

This brings us to two facts about OPEC: First, Saudi Arabia is preeminent among equals, and OPEC policies are shaped by Saudi priorities. Second, OPEC's break-even price is highly variable among its members, particularly because the break-even price is a combination of lifting costs (typically under $10) and budgetary requirements by the primary stakeholders - the governments who own the oil. In today's complicated geopolitics, break-even price for some OPEC governments has an implicit imperative to maintain social order. What crude price is best to choke off domestic recruits to ISIS in Iraq and Syria or Boko Haram in Nigeria? For instance, Venezuela requires a crude price of more than $150 to balance its budget. Comparable figures for Qatar, Nigeria and Russia span a wide range anywhere from $70 to $130.

On the other hand, what will be the impact of lower prices on global demand for oil? As a matter of reference, world consumption of gasoline and petroleum/gas rose by 6 and 10 percent respectively since 2008, while crude prices fluctuated between $30 and $145. China and India were the significant engines for this growth. Demand for oil will clearly exceed its historical trend, buoyed by the prospects of lower prices, albeit short-lived.

Where does all this lead? In July 2008, the spot price of crude approached $145. Peak oil advocates as well as the prevailing opinion leaders in energy matters were predicting prices above the $200 mark - it was the end of oil because the world was "running out" of oil. Today, an accidental convergence of interests between leading members of OPEC and shale producers in Texas and North Dakota points to a new quasi-equilibrium in crude prices - somewhere arguably in the range of $60 to $90. Regional conflicts and serious threats to the supply of oil can, as in the past, cause spikes above this window. One certainty is that American shale producers are here to stay and not fading into the twilight. Their resilience in turn will likely set off a chain reaction among the technology laggards of OPEC toward urgent modernization (hence, collaboration with western companies). The price war initiated by OPEC targeting Texas may, thus, boomerang to engender structural improvements among its less efficient members. The net outcome will be less volatile and more robust oil supplies in the years ahead - the Tex-OPEC dividend, albeit by coincidence.

Ten years from now, in 2024, we may look back and thank OPEC for onsetting the age of stability to the world oil markets.