Two major oil producers are cut off from international markets when the United States imposes sanctions. The safety of oil tankers is at risk. The possibility of conflict looms in the Persian Gulf.
In a CNBC interview on June 19, former Secretary of State Condoleezza Rice said, “If we had been sitting here 10 or 15 years ago, with that kind of tension in the Strait of Hormuz, we would have seen the oil prices spike through the roof.”
Just two weeks later, on July 4, Britain seized an Iranian oil tanker in the Strait of Gibraltar, and on July 19, Iran responded by seizing a British tanker in the Strait of Hormuz. Oil markets barely responded. On Sept. 14, a drone attack on Saudi Arabia disrupted 5.7 million barrels a day of export capacity. On the next trading day, the Brent crude oil benchmark price jumped nearly 12 percent. But within days, it dropped back to its pre-attack levels.
The price of oil continues to rise and fall in response to commercial pressures and investor sentiment. But even an attack threatening 6 percent of world production did not move oil markets substantially.
What has changed to make that possible?
At least part of the explanation lies in the strength the United States has gained in the oil markets, without the guidance of a controlling authority and, remarkably, without being a low-cost producer.
That strength comes, in part, from a very large, newly developed resource known as tight oil. Tight oil is a light crude oil extracted by horizontal drilling and massive hydraulic fracturing, or fracking. (This new resource is not to be confused with “shale oil,” which is produced by a centuries-old but rarely used technique of heating shale to about 500 degrees Celsius, or about 900 Fahrenheit).
Tight oil is close and convenient on land in the lower 48 states — not in deep water, not in the Arctic and not in remote corners of the world where operations are difficult, expensive or risky.
Tight oil resources exist outside of the United States, but except for a relatively few projects in Canada and Argentina, they have not been exploited. There are a number of reasons for this, including local opposition to fracking and unfavorable geological settings. But the primary reason is the structure of the industry.
Almost everywhere, the petroleum industry is dominated by nationally owned or big international companies with large inventories of fossil fuel resources. Logic dictates they develop their lowest-cost projects first.
Outside of the United States, tight oil is almost never the cheapest option, because the drilling and fracturing of horizontal wells require expensive equipment. Inside the United States, tight oil projects are compatible with a nearly unique landscape of independent producers who can operate on small margins but who lack the resources to undertake projects offshore or in remote locations.
This significant new resource does not make the United States a swing producer, an entity that controls spare capacity that can move markets quickly. The American oil industry today operates without spare capacity — large amounts of oil held in reserve that can be put on the market quickly and for a relatively sustained period. Nor is there centralized control over its nearly 9,000 independent producers.
Saudi Arabia is a swing producer. It has both spare capacity and centralized control of oil output. Until recently, it has quickly adjusted its crude oil production by as much as 1.5 million barrels per day to stabilize the price of oil.
However, a swing producer is not the same as a dominant producer, which has market power over the medium to long term. Dominant producers can raise prices by withholding supplies, or can capture market share by releasing supplies. OPEC was a dominant producer in the 1970s and early 1980s. There are no dominant producers today; no nation or group of nations can impose its will on oil markets.
Any attempt by oil producers to support high prices by cutting production is likely to be met by a surge of American oil. The United States oil industry has the ability to increase its rate of production by more than one million barrels of oil a day every year and has done so regularly since 2011.
Furthermore, the countries of the Middle East can no longer afford to increase their share of the market by flooding it with cheap oil. Large amounts of oil can be produced in the countries surrounding the Persian Gulf for as little as $10 per barrel, much lower than the $40 to $50 cost of tight oil in the United States. But the profit requirements are much different in the two regions.
The nations of the Middle East and North Africa depend on income from their national oil companies to pay for public services. This income, in turn, depends on the price of oil. The requisite oil price to balance a nation’s budget is called the fiscal break-even; according to the International Monetary Fund, that ranges from $50 to $120 per barrel for the nations of the Middle East and North Africa.
Without significant fiscal reforms, which seem unlikely, the political stability of these states is at risk if the price of oil remains much below the fiscal break-even for an extended period.
The situation is much different for independent American oil producers. Even modest profit margins enable domestic tight oil producers to sustain and increase production. If oil prices decline, drilling will slow, but production continues. Although the output of newly drilled tight oil wells declines quickly, a large inventory of older tight oil wells continues to produce, at very low cost, in the absence of new drilling. OPEC discovered this to its dismay when, using price cuts, it tried and failed to drive tight oil out of the market five years ago.
Therefore, while the United States is not a swing producer or a dominant producer, tight oil in the United States effectively blocks others from exercising dominance in oil markets.
What does this mean for the industry in the foreseeable future? Eager investors and low interest rates fueled the rapid pace of tight oil development. Independent oil companies have done their part by putting their profits back into expanding production. Normally this would be attractive to investors, who see growth as contributing to the value of their equity stakes.
However, in the last few years, investors have become disillusioned. They now confront the possibility that action to control carbon dioxide emissions will leave fossil fuel assets stranded in the ground. In these circumstances, building for the future no longer looks attractive, and investors favor immediate returns over long-term growth.
Are investor fears justified? The world consumes 100 million barrels of oil a day. Because of resource depletion, each year the production from existing fields declines by about six million barrels a day. World oil consumption grows by about one million barrels per day each year. Therefore, on present trends, seven million barrels a day of new production will be required every year. This is the “business as usual” world the oil industry is familiar with.
In its most aggressive decarbonization scenario, the International Energy Agency reckons that for global temperatures to rise by less than 2 degrees Celsius on average, global oil demand must decline to 70 million barrels per day by 2040. This represents an average decrease of 1.5 million barrels per day each year.
Assuming the aggressive decarbonization scenario is attainable, the petroleum industry will have to find about 4.5 million, instead of seven million barrels a day of new production every year. It will do this by avoiding the most difficult, expensive and risky prospects. Increasingly selective investment strategies will favor nations that offer oil at low cost, in politically stable and market-friendly environments − not an altogether bad prospect for a mature industry.