The effects of the fall in oil price on the US shale market
Since June 2014, the price of oil has fallen over 60% to about $50 per barrel of Brent Crude. This reduction in price to below the commodity’s pre 2008 value has has had a number of political, financial and economic effects; especially on the US shale market.
The classic model of supply and demand provides an interesting starting point when analysing the price. If the devaluation is a result of a fall in demand, this would present a worrying indicator as to the state of the global economy. Oil is the most traded commodity and contract in the world and if the reduction in price is due to the change in demand we should consider whether presents an advantage, lowering the cost of production and import, or whether this presents a threat, either as an indicator to a reduction of production or as a financial pressure to the debt that is leveraged against the oil market.
Goldman Sachs analysts state that there is actually an excess in supply caused by a change in the reaction function used by OPEC to moderate the introduction of new oil into the market. As demand falls, the usual course of action is to reduce production to maintain prices, however the Saudis appear not to be reducing supply shocking the market. Unless there are knock-on effects, this presents a benefit to the market; however, there are two sides to the story and the reduction in demand may play a stronger role in the setting of this price.
Even with volatility, oil prices, for a good 25 years, from the mid 1980s to the end of 2007 traded at the 35$ per barrel – about one third value for the $110 level that the value has fallen from. In real terms, this has been the highest sustained level (excluding wars and conflicts) due to gross increase in demand from China and other developing countries shortly after 2008 causing a demand shock that oil producers have taken a number of years to catch up to.
With the oil producers unable to increase supply in the short term, the price had increased 3x shortly after the financial crisis. One could speculate that this increased price may be a factor contributing to the miserable growth to western economies up until this date. Having said that, the new increase in supply has now pointed to one positive factor highlighting the medium-term elasticity of the oil producers owing to a 90% increase in US shale output.
For the last 3 or 4 years, producers have been working to increase supply, however concerns could be raised at how quickly the change in price occurred, given that its taken the US 4 years to increase output from 5mb/d to 9mb/d and 6 months for the price to fall from $110 to $50.
The increase in US production has been masked by reductions in north african oil. In 2011, the Libyan civil war thwarted production, with output falling from 2mb/d to next to nothing at two points in a space of 3 years, and fighting in the Nigeria River delta has caused a reduction in the rate of export due to the number of companies needing to declare force majeure.
The high price of oil lead to an increase in supply throughout the world – including OPEC, Libya and Nigeria, however it wasn’t until August until the supply surged with OPEC increasing supply by 891kb/d and Nigeria increasing exports by 380kb/d in August 2014 leading to an excess supply situation.
This current surplus of supply appears to mimic parts of the 1980s oil glut where after a sustained period of abnormally high oil prices, rates to below a nominal low of $8 There are five parallels that can be drawn on. Firstly, in the 1980s, high price per barrel introduced a range of new suppliers into the market as is today with new shale production. Secondly, there was an aggregate demand weakness in The West. Thirdly, Saudi Arabia refused to cut supply in both cases causing OPEC to come under strain. Fourthly, it is likely that Russia will suffer most as a result of the oil price correction, and finally, developed nations with strong import markets stand to gain the most from the correction in oil price.
In the 80s, the oil price was allowed to fall through an excess in supply from the Saudi to its all time low value deliberately to bring into line members of OPEC who were refusing to cut production in response to a weaker demand following threats of peak oil. Once oil production was cut, the price levelled at $18 per barrel.
The difference this time is that the Saudis are using their dominant position to put a squeeze on the US shale oil industry. Not only has the decline in the oil price added a financial pressure to “stripper” oil wells – small wells with very little output, but also to reduce the attractiveness of investing in new locations. As shale oil wells typically have a very short lifetime, a lack of new wells could cause the US shale industry to dry up in the mid-term; appearing to be a subtly tactful move from the Saudis.
The typical break-even for shale oil is in the range of $40-$70 per barrel depending on location. The financial outlook in the short-term is very bad as the market is teetering on the edge of bankruptcy. This wouldn’t have an effect on short-term production, if anything would extend the production, as creditors, in the event of bankruptcy, would seize the assets and try and maximise the value from the assets. However, the problem is that in the mid-term, new shale wells will not be financed if oil continues to remain at its current price.
Although it may not currently be as financially viable as it used to, shale oil will still be around for a while to come. The elasticity it provides where production can be scaled is much more powerful than the conventional oil wells. We saw how post-2008, the US was able to support its economy through a near doubling of shale output over 3 years in response to high prices following demand from China. There is no question about it that as the US tries to reduce its dependency on foreign oil, the elastic supply that shale provides will guarantee it’s own future.
Drawing upon the parallel with the effect of the fall in oil price to Russia, the largest unknown, possibly negative surprise, will be the political, financial and economic effects that would arise from a crippled Russian oil economy. Russia needs the oil price to hover around $100 per barrel to balance its budget. At current prices, the economy will come under strain. Putin will have to respond in some shape or form some time soon: reserves will have to be drawn down and budget cuts would have to follow.
Russia could use this as an opportunity to cleanly extricate themselves from the mess they created in Ukraine, however this appears unlikely for the simple reason that Putin seems to have wagered his political future on foreign policy bravado. It appears more likely that Putin will have to clamp down even more domestically to entrench his position. A drop in oil price would lead to financial hardship and an increase in the levels of despotism as the government struggles to maintain the political status quo.