The energy markets are in turmoil.
A supply glut has cratered oil prices and the Organization of Petroleum Exporting Countries, or OPEC, has refused to cut production targets to stabilize prices to sustainable levels. In response, analysts and observers of the energy industry have been quick to pronounce OPEC’s demise. That might be premature analysis and exaggeration.
To be sure, the events roiling the oil markets currently signal a structural shift of power and economics in the oil market. However, OPEC is not going anywhere anytime soon. There are three reasons for this.
1. The economics of oil production favor OPEC’s dominance in the markets. A bit of context is necessary to understand this point. Since the oil shock of 1973, when Arab states punished the United States’ support of Israel with an embargo, Saudi Arabia has been the de facto “swing producer” of oil. This means that the kingdom, which possesses the world’s largest oil reserves, controls prices by turning the production spigot on or off. Profits of major oil producing nations and companies were dependent on Saudi providence. Despite cheap production costs, which average between $20 and $50, Saudi Arabia maintained high oil prices that ensured profits for all stakeholders and producers.
By refusing to cut down production in its oil fields recently, however, Saudi Arabia has placed the onus of controlling prices on an international community of non-OPEC members, such as Iran and Oman, and specifically, shale oil producers. Plentiful oil reserves have ensured that production costs for non-OPEC members are comparable to those for Saudi Arabia.
But, the story is different for shale oil producers, whose average production costs are typically double that of Saudi Arabia’s costs. According to Morgan Stanley, the breakeven price of American shale oil projects is around $76 per barrel of oil. Given current oil prices (below $50) and projected future prices (below $70), it is safe to assume that shale oil producers will have miniscule profit margins (or even losses) as compared to Saudi Arabia or OPEC at these price points. Thus, there is little incentive for shale oil producers to take on the mantle of swing producers.
2. Based on current estimates, OPEC oil reserves may outlast shale oil reserves. Research indicates that output from shale oil wells declines rapidly – almost 50% to 75% in the first year. In comparison, the decline rates for oil fields in Saudi Arabia are no higher than 20% per year.
Then, there are the proven oil reserves. According to the latest data from the Energy and Information Administration (EIA), the United States has proven oil reserves (or, the amount of oil that can be extracted using current technology and under current geologic conditions) of 33.4 billion barrels. In contrast, the largest oil field in Saudi Arabia – Ghawar field – has estimated reserves of 75 billion barrels. Remember, the Ghawar field is just one of the eight oil fields in Saudi Arabia.
3. A decline in returns for investing in the shale oil industry. Although it has made significant progress within an extremely short span of time, shale oil is a relatively nascent industry. It has largely been financed through debt and bonds. In fact, the total debt for American exploration and production firms has doubled to $260 billion since 2009 and bonds from the industry make up 17.4% of all high risk or junk bonds in America. Low (or negative) profit margins may make it less attractive to investors looking for quick returns. In turn, this could negatively affect research needed to develop new technologies to make the industry cost-competitive.
It is no wonder then that, despite dire predictions of OPEC’s decline on the world stage, President Obama, leader of the world’s most powerful nation, cut short his visit to India to pay his respects to Saudi Arabia’s new king. America needs OPEC more than OPEC needs America.