When it comes to the oil price, an economist’s forecast is only as good as the next person’s guess … here at io, we take a look at the macro economic factors affecting the oil markets today.
It was over 20 years ago whilst studying economics that I was introduced to the notion of perfect competition with a raft of demand and supply diagrams, the staple of any student … back in those days, examples of markets in a state of perfect competition were hard to come by – although nowadays, with the internet and companies like eBay and Uber operating, I’m sure those studying have much more interesting debates. The concept of a monopoly, or even more prevalent oligopoly, was indeed a much less theoretical debate. The oligopoly is often characterised by collusion of some sort be it overt or covert. An example of overt or formal collusion in the form of an organised cartel designed to control supply to maintain price support or market share had a clear example in the Organization of Oil Exporting Countries (OPEC).
With a stated mission to “coordinate and unify the petroleum policies of its member countries and ensure the stabilization of oil markets, in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry.” OPEC’s oligopoly is regularly cited as an example of an international cartel. With a share of world oil production exceeding 50% in the 1970s, and currently comprising 43%, OPEC has historically controlled supply to manipulate the global oil price. However, with the rapid development of the United States’ tight oil, OPEC’s power is weakened and their oligopoly and cartel actions are currently proving ineffective. This has an impact not only on oil price but also on the makeup of hydrocarbon portfolios being developed by oil companies, with a shift towards gas and a renewed (excuse the pun) interest in renewables. At io, we look at what this means for the global oil industry.
The history of OPEC
Since its formation in 1960, OPEC has acted as a controlling force on the global oil price. Comprising some of the world’s largest oil producers, the group has coordinated oil policies to exert its market power and collectively benefit from higher oil prices brought about by the restriction of supply. For the past fifty plus years, OPEC’s strategy has worked well and although it relies on the member states having a significant proportion of the global oil reserves such that they can materially affect the global oil supply, it also depends on the previously high barriers to entry (cost and time) to bringing on new oil production. Any change to the geographical demographic of oil reserves, and the speed at which oil production can be ramped up or cut back in response to a price change impacts the ability of OPEC nations to control the supply. This is exactly what the onshore US tight oil revolution has achieved.
Impact of US tight oil
Technology advances in the late 1990s and early 2000s saw the rise of hydraulic fracturing and horizontal drilling; these advances in turn unlocked the first shale gas reserves in the US. After identifying a potential oversupply of shale gas, 2009 saw EOG drill the first US tight oil well in the Eagle Ford Basin. Along with the Permian and Bakken basins, this kick-started the US onshore oil revolution. With a lower barrier to entry than offshore developments, EOG was quickly joined by many more US tight oil producers and the oil from these producers has resulted in the US becoming a credible challenger to OPEC’s Saudi Arabia’s position as the top oil producer worldwide. Couple this with the 2015 lifting of the US government’s export restrictions on oil, and the US has become a major competitor to OPEC.
OPEC’s initial response to this disruptive challenge was to do the opposite of their previous actions and let production increase and drive the oil price down, which led to the 2014/15 collapse in the oil price, in an attempt to drive the US tight oil producers to cut back activity. However, the US tight oil producers proved more resilient than OPEC anticipated and the tactic was unsuccessful as the OPEC member nations could not sustain the low prices. In fact, this action may have inadvertently given the US producers the drive to lower supply chain costs, the drive to increase the efficiency of drilling operations and the drive to target the most productive areas.
More recently OPEC, in conjunction with the other major oil producing force, Russia, changed tact, moving to restrict oil supply and attempt to increase the oil price. However, this supply restriction has not delivered the desired effect: the dynamic US tight oil producers quickly filled the supply deficit, showing how they can mobilise rapidly when oil prices rise above $50/bbl. Supporting this, the Baker Hughes rig tracker reports a doubling of drilling rigs operating in the US since 2016. The result is that any restriction of supply brought about by OPEC production quotas is promptly filled by the US tight oil producers. OPEC’s ability to control the global supply of oil, at least for now, is greatly diminished.
As US tight oil starts to exhaust the low hanging fruit reserves, OPEC may hope this will bring a rise in extraction costs for that oil and start to squeeze the producers. However, the innovative nature of tight oil, borne out of the increased competition driven by relatively low barriers to entry, has resulted in the offset of extraction cost inflation by the development of evermore efficient extraction techniques. For example, walking rigs, which can move from well to well, have been deployed, allowing for a greatly increased flexibility and reduced time to produce for the tight plays.
What it all means
The tight oil revolution has broken OPEC’s oligopoly. It could be argued that the oil market has moved from being dominated by a cartel to something closer too perfect competition.
The vast reserves, relatively low barriers to entry and efficiency improvements mean that OPEC is unable to affect the global oil price in the way it once could. The innovative efficiencies developed by US tight oil prevent OPEC from holding the oil price low enough for long enough to affect it without harming its own profitability; contrastingly, if OPEC tries to restrict supply to raise the oil price and maximise their own profits, the dynamic producers fill the deficit, preventing a material increase. In the future, it may not just be US tight oil reserves challenging OPEC. In 2013, the US Energy Information Administration reported Russia, China and Argentina all had significant technically recoverable shale oil resources; albeit maybe not all have the same macro ingredients that made the US a runaway success.
With the end of OPEC’s oligopoly, it is no longer the stabilising force it was. The oil price cannot be manipulated artificially and we appear to have entered a lower for longer, if not lower forever, environment.
This is driving oil companies to look both at lower cost developments in order to maintain profitability and to move their focus away from oil to gas developments. Most recently, this has been exemplified by BP’s decision to open a new region of operations by farming in to Kosmos Energy’s Tortue field in Mauritania and Senegal.
Rather than wait for the oil price to return to the previous highs, the oil industry must accept OPEC’s power to dictate the market is diminished. Within the lower forever environment, the industry has to work with the prevailing economics to ensure maximum value is derived from the monetisation of a field. The industry must also learn from the dynamic and innovative approach employed by US tight oil in bringing reserves to market. io has extensive experience in subsurface, LNG and economics; this holistic skill set allows us to provide innovative concepts supporting the development, production and monetisation of projects. To find out more about how io’s team of experts can make your projects profitable in the world of perfect competition, contact us at firstname.lastname@example.org.
Author: Tim Stringer, Head of Economics, io oil & gas consulting