Welcome to the new oil order
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The airwaves and Twitter are full of commentary about how Saudi Arabia, the rest of Opec and Russia can balance the market by cutting production and raising prices.
The idea that these traditional producers can impact the markets on their own is based on old world thinking where Opec’s low-cost producers and some additional traditional producers can impose their political will to counter market forces.
The unconventional oil revolution has rendered such thoughts obsolete.
That is because the new energy world order is one in which the US, whose production was once half that of the other two producer giants, is now on a par with them. And that turns out to make a big difference.
In the old world oil order the US did not count — with its declining output it was a taker of prices; with its permanent importer status, it was a bystander to global oil politics and production decision-making.
The shale revolution in the US has made a huge difference. The US is now arguably the world’s largest oil liquids producer in the world, if you take into account crude oil production and other supply like liquefied petroleum gases (LPGs), biofuels output and the incremental volumetric gains from having the largest refining system in the world.
On paper the US might produce 9.3m barrels a day against Russia’s 11.1m b/d and Saudi Arabia’s 10.3m b/d. Add everything that looks and smells and is used as oil and the US is the biggest of the lot, producing 14.8m b/d versus the kingdom’s 11.7m b/d, versus. Russia’s 11.5m b/d.
We are used to old thinking — a world of producers comprised of Opec plus critical non-Opec producers including especially Russia, Mexico, Norway, Oman and maybe a couple of others. The new order has rendered Opec irrelevant, an organisation crippled by disruptions and sanctions, with no will to work as one, able to be a negative force by bringing prices down, but incapable of finding a way to put a floor under prices.
The new world is one of three giant producers whose combined liquids output is about 40 per cent of world markets. All three of them play a role and one of them — the US — cannot constitutionally play a role to constructively counteract market forces. Indeed it is the very embodiment of market forces.
The three giants of the oil market are about the same size. But size is only one element. Who makes decisions is another. In the Kingdom of Saudi Arabia there is one decision maker on who turns the valves on and off. In Russia it is a bit more complicated, but at the end of the day it’s a government that’s basically in charge.
The third and biggest of the giants, the US, has production based on competitive decisions of hundreds of independent producers, which now, unshackled, can sell oil at home or abroad.
That makes an enormous difference, especially when considering the nature of marginal production in the US, which comes from shale resources. These rocks are not only superabundant, but they can be exploited at a relatively low cost. Just compare an offshore well at $170m with a vertical shale well that costs under $5m, with a five-year payout for a successful deepwater well versus a mere five-month payout for a shale play. And multiply a single, individual shale well by hundreds of wells and hundreds of decisions and you get a new world order.
With productivity gains in the US rising and costs of exploitation falling in a deflationary environment, if the traditional producers succeed in reining in production, prices will rise and US drilling will resume and US production will again surge.
Whatever the gossip might be about the need and potential for the old world players to collude to put a floor under prices, at least the leaders in Saudi Arabia understand that it is not that simple — especially now with Chinese oil demand stagnating and Iranian production rising.
If they cut production they confront two problems — a potential loss of market share to Iran, which rightly and righteously believes that others have taken their market share during their years under sanctions, and a subsidy to US independents whose production can grow by 1m b/d in a year or so, once prices rise.
It is time to throw away the lenses of the 40-year-old world oil order and come to grips with the new and permanent realities of the market.
Ed Morse is the global head of commodities research at Citi.
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