Oil markets are sending confusing signals at a time when more confusion is the last thing anyone needs. When Russia walked out on OPEC+ rather than contribute to more output cuts, Saudi Arabia turned on the crude taps. Whatever Riyadh’s intention, this “price war” was quickly made meaningless by the impact of the new coronavirus on global oil demand. The price collapse has been beyond anything anyone could have imagined.
Now, storage room for crude is becoming scarce. Analysts warn darkly that plunging prices may threaten global economic stability. Equities follow the oil price news. Everyone seems to agree that prices should stop falling; and yet no one seems to argue that a very low oil price is exactly what the world’s economy needs to recover.
The combination of price war and pandemic is also creating strange bedfellows. Some American shale producers are advocating that their country blocks Saudi oil imports, others want to talk to OPEC. President Donald Trump’s government has expressed an interest in cooperating on global oil supplies with Saudi Arabia and Russia; it’s nudging OPEC+ to reconvene, or an even wider group of producers to meet. Could we be witnessing the emergence of an unholy alliance of Saudi Arabia, Russia and the U.S., to “manage volatility,” and incidentally shore up the price of oil?
Cards on the table, I hope not.
Oil is still the lifeblood of modern commerce. It takes seven liters (1.85 gallons) to produce $100 of global gross domestic product. This is better than the 10 liters of 30 years ago, but the price of oil still matters.
Today, the world has three centers of oil production, each with its own governance structure, its own economic and strategic interests, and each with an entourage of similarly structured, smaller producers in geographic proximity. Taken together, these three — the U.S., Saudi Arabia and Russia — account for 45% of global liquid hydrocarbon production (almost half of which now comes from the U.S.).
In this new world, U.S. energy “independence” (or “dominance”, as the Trump administration likes to call it) has become an important strategic asset. It took a little longer for the economic implications of becoming a net oil exporter to sink in. A flurry of presidential tweets demanding lower prices notwithstanding (aimed at an electorate with big cars and low incomes), the U.S. economy is on the verge of becoming a net beneficiary of rising oil prices, if it isn’t already.
The shale industry, from which all this change originates, is in the midst of a difficult process of financial restructuring — not untypical for a new industry but painful for individual companies. Many firms have seen financial constraints emerge, long before the coronavirus struck.
The collapse of price support from OPEC+, signaled by that Russian walkout and Riyadh’s reaction, would have sounded the death knell for many shale companies even without the pandemic. However, if Moscow’s — or Riyadh’s — strategy was to kill the industry, it would almost certainly have failed. U.S. finance thrives on such disruption. Even now, American shale assets will be mothballed and change hands, debt will be restructured, and hydrocarbons will flow, quite possibly at a more efficient cost per barrel. Sources of financing may change. The technology is here to stay.
Presently, Saudi Arabia has every incentive to come to an output agreement. Its society is simply too dependent on oil to let its price stay on the floor. Russia, meanwhile, is vulnerable to a global inventory overhang, which would force its producers to shut in production. The risk to its fields makes it an unlikely candidate for an all-out dispute. Of the three main producers, the capacity for a longer price “war” is actually highest in the U.S.
But could the threat to America’s newly strategic shale industry from price competition really bring Washington into a dialogue with OPEC? Should it?
In a shrinking market, the low-cost producer is king. Left alone, a global oil market would emerge in which large OPEC producers from the Gulf (the cheapest) would have the first go at selling whatever quantity they desire. A mix of global companies would be next; this second layer might indeed be tilted toward Russian operators, with low production costs and the helping hand of government. Unconventional producers — nimble, numerous, and price responsive (as in the U.S. shale patch) — would close off the system. They would produce the residual, and the cost at which they’re capable of doing so would set the global price of oil.
This would be a market as stable and efficient as it gets. It is actually what we have today, when factoring in the restrictions that falling oil demand growth will place eventually on the ability of groups like OPEC and OPEC+ to interfere to raise prices.
Beyond the immediate emergency, meaningful long-term cooperation to “stabilize” prices would require state intervention or quotas; or U.S. import restrictions. Any of these would mean curtailing the benefits of competition and open entry to which the U.S. shale industry owes its existence. In the short term, such measures would fly in the face of supporting the post-pandemic economy by pushing up fuel costs. In the long term, they would curtail the capacity to innovate on which we depend so heavily in the transition to cleaner fuels.
So the answer on whether the three big producers should be joining hands on the crude price is no. The rest of the world has very little to gain from more intervention in global oil markets. What’s needed instead are better rules to safeguard competition on a global scale. This may be wishful thinking. But the temptation to “manage” the market, now or when peak oil demand approaches in earnest, should be resisted.