[Editor's note: A version of this story appears in the June 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]
Many executives in the U.S. oil industry have vivid memories of the “Arab Oil Embargo” of 1973. Now that the shale bonanza has vaulted the U.S. into the position of a major oil exporter, there must be no small sense of satisfaction among those who recall all too well the long lines at gasoline stations and lowered thermostats of their youth.
For the perceptive, there must also be a strong sense of irony. Because in becoming a major player in petroleum, the iconic independent producer has adopted wholeheartedly the objective of a stable price range within sustainable levels for both buyers and sellers. That of course, has been the objective—at least the economic objective—of OPEC from its founding in 1960.
In the giddy first years of the shale era there was fanciful talk of “energy independence.” That had little to do with economics or logistics and a great deal to do with exorcising the demons of energy dependence in the 70s. What has developed is energy interdependence. Where one stands depends on where one sits, and unconventional development means that the U.S. now sits at the head table with Saudi Arabia and Russia.
“Some people believed that shale would free the U.S. from global geopolitics and supply disruptions,” said Helima Croft, managing director and global head of commodity strategy at RBC Capital Markets’ research division. “That foreign-policy promise from the Permian has not materialized.” If anything, becoming a major exporter of crude and LNG, beyond the existing robust business in fuels and petrochemicals, has increased the involvement of the U.S. in global energy dynamics.
The fulcrum for the lever of sanctions against Iran and Venezuela, Croft explained, is that U.S. production continues to expand. Of course, the sanctions are taking heavy barrels out, while the U.S. is putting light barrels in, but being a major exporter of any crude puts the U.S. at the table.
That position has been acknowledged by OPEC. “I have had OPEC officials tell me that if they had known how it would all play out, they would not have made that announcement late in 2014 that they were holding production steady,” said Croft. “They knew prices would drop, but they were expecting a short stay in the $70-a-barrel range and that shale would break. No one saw oil with a three handle on it.”
In a large irony, it was domestic politics that drove OPEC to back down. “Could they have held out longer?” Croft asked rhetorically. “Some investors say shale was starting to break. There were bankruptcies. But sovereign producers would have gone bankrupt first. The social contract they have with their citizens is prosperity for loyalty. Their oil sustains their economies. Just look at what happened recently in Sudan and Algeria. Those governments fell because they did not deliver the prosperity.”
Four years from the low point, oil prices have reached a “tolerable place,” said Croft. “Seventy-five dollars for Brent and $67 for WTI [West Texas Intermediate] is fine.”
Greg Haas, director of Stratas Advisors, concurred. “Currently we are at $65/bbl [barrel] for WTI, at least $60 plus. Brent is $70 plus. That looks like the correct range. A good majority of the wells in the U.S. can be economical at $50 or a little above. The question then becomes: Can OPEC be economical at $50 plus?”
Saudi Arabia is the low-cost producer. “Their finding costs are super cheap,” said Haas, “in the single digits. But when Brent was at or below that level, their fiscal troubles came to the fore quickly. [Because their national budget is tied to oil exports] we think their floor price is closer to $70 or $75. Regardless of low finding costs, that is what they need to keep their economy going.”
So the U.S. and Saudi Arabia are yin and yang: the U.S. as the high-cost producer, but with a private market, no baggage on the price. Saudi has oil for the asking, and then extracts from it the wherewithal to run the kingdom. “So we have reached petroleum détente. Russia is just along for the ride,” Haas added. “They are somewhere in between on costs.”
Twice The Trough But Half The Peak
That situation implies the end of the ‘lower-for-longer’ theory that was in vogue since the price collapse of late 2014.
“For several years, people were speculating what kind of recovery in oil prices there would be,” said Haas. “There was talk of a V-shape, or a U-shape, or a bathtub. “
Prices have doubled since the trough but remain half of the peak. Rather than a recovery per se, it seems more like the price electron has simply moved to a higher price orbital. That looks sustainable. “It is hard to imagine Brent getting back to $100 or $140,” said Haas.
Détente confirms that OPEC has accepted the U.S. as a major oil exporter. It is widely understood that the Thanksgiving turkey OPEC delivered in 2014 by announcing a production high and causing prices to collapse was intended to beat back shale producers. “Whatever the intent, look where we are now,” said Haas. “Prices are higher for both WTI and Brent, and U.S. production is greater.”
A tolerable price range aside, Croft hastened to add, the situation is highly unstable. “We have two major exporters under sanctions. We have yet to see how Iran reacts. Libya is on the verge of civil war. It is a very chaotic situation, and will be a real test of whether or not U.S. exports are enough to keep things balanced. I would not necessarily take that bet. Shale can certainly do some heavy lifting, but we don’t know how much it can sustain.”
“The U.S. sanctions are starting to bite on Iran, and the collapse of Venezuela means that OPEC as an entity has taken a hit. Coupled with the rapid growth in U.S. oil production, OPEC’s ability to move prices is now hampered absent cooperation from other producers.”
—Kenneth B. Medlock, Rice University
There is a historical pattern to the geopolitical premium that has been factored into global oil prices. Any premium arising out of uncertainty of supply is a factor of a tight market, said Kenneth B. Medlock III, a Baker fellow in energy and resource economics and senior director of the Center for Energy Studies at the Baker Institute for Public Policy at Rice University.
“If you look back to 2008, there was very little inventory, OPEC’s spare capacity was very low, and there was little supply responsiveness at the margin. Any air of uncertainty puts that premium on,” said Medlock.
“It is easy to forget how quickly the upstream evolves,” he added. “In the 70s and 80s, when oil prices were high, every mom and pop borrowed money to drill for oil. There were a lot of bad loans made followed by waves of consolidation. Shale is no different. The first step is always the entrepreneurs. Over the next five years we will be seeing a lot more consolidation.”
Contrast that to just six years later. By 2014, the shale bonanza had begun to show its size, and the U.S. was already discussing the resumption of exports. “OPEC was trying to determine if shale was a long- or short-term phenomenon,” said Medlock. “It seems quite clear that it is now a long-term phenomenon. By the end of 2014 we also had bloated inventory because demand growth had slowed. So, there was little reason for any geopolitical premium. Moreover, the emergence of shale has added a very responsive new source of supply, meaning it will take much more substantive geopolitical pressure to drive a premium in the market.”
As evidence he noted that there have been several current dislocations in global crude supply, with no evidence of any lasting premium moving into prices: Venezuela’s implosion, U.S. unilateral sanctions on Iranian crude and ominous pronouncements out of the new government in Mexico indicating an about-face from the policies and legislation of the previous administration to open the energy sector to foreign investment.
As if to underscore Medlock’s point, there was a muted reaction to the sudden pronouncement out of the U.S. administration April 23 that it would not renew waivers of the sanctions against Iranian crude. Brent moved higher by about two and a half dollars a barrel that afternoon, but ticked lower the very next day.
“Even with all that going on, I don’t really see the oil market in a situation where a large risk premium could be reinjected,” said Medlock. “Maybe a little, but not much. If anything the response by U.S. producers to the price collapse in 2014-15 showed the world how responsive shale is to the international market. The new presence of another major exporter and the ability of fringe producers to react in a short time significantly reduce the ability of OPEC to move the market by itself.”
Croft at RBC is not sanguine that the other two North American producers can pick up much slack. Looking north she is rueful. “The current situation is so set up for Canada. Who else has the heavy barrels U.S. big refiners need? They just have not kept up with the infrastructure so they can’t answer the call.” That is one area where Croft credits Saudi Arabia: “They don’t just have the production capacity; they have the infrastructure and the logistics.”
Canada should be a major exporter, said Haas at Stratas. Its internal political frustrations at being unable to get molecules to market have been well reported. “The shortage of pipelines means they can’t get crude to buyers who are willing to pay more,” said Haas, but that is actually a common problem.
Outside of OPEC, the two other North American producers that could play larger roles but are hamstrung by internal politics, said Medlock. Canada, as has been well reported, has a serious pipeline constraint building new pipelines or even expanding existing ones.
With Ottawa effectively nationalizing one line expansion, and a new pro-development government in the main energy province of Alberta, it is expected that progress will be made on getting more molecules to market. It will be several years, but “once those pipes exist, Canada becomes a larger and more market-responsive exporter,” said Medlock.
Looking south, the situation in Mexico is more recondite. The new left-leaning president—Andrés Manuel López Obrador, often known by his acronym, Amlo—has called for massive domestic investment in upstream and downstream and has been critical of foreign investment. “Amlo is definitely playing to his base,” said Medlock.
That stance has been criticized within and without Mexico as fuzzy nostalgia for a golden age of Pemex, but Medlock noted that Amlo has approached the energy question as part of his anti-corruption campaign. “He is getting very high approval ratings thus reinforcing his stance,” said Medlock. “There is a lot of risk. The optimal approach for foreign companies is to stay engaged by acting on previous investments, but not to actively seek new investment at the moment.”
The new administration in Mexico raised eyebrows with its rumblings against foreign investment, but RBC’s Croft noted the pattern of production has been down for a while. The rhetoric is new, but “if you pull the data on Mexican production, it has been declining for some time due to lack of investment.”
Dominant Firm Theory
Beyond the balance of the big three, the two other variables in the equation are the second-tier producers, and the question of demand, noted Haas. “There seems to be some expectation within OPEC for diminished production from Iran, because of the U.S. sanctions, from Venezuela, which could be in a catastrophic situation, and perhaps even from Libya, Nigeria or Algeria. With any of that, there could be some slackening of curtailment by OPEC, specifically from Saudi Arabia.”
That willingness to raise production if output from other member states declines indicates contentment with the current price range. That means OPEC leadership has accepted the reality of the U.S. as a major exporter.
“Refineries in California and on the East Coast are effectively isolated from Permian production by the Jones Act,” Haas explained. “Any supply disruption will cause price dislocation.” The Jones Act requires that trade between U.S. ports be handled in ships owned, operated and crewed by U.S. citizens.
While the discussion of petroleum politics and economics usually involves supply, Haas stresses the importance of demand. “At the end of the day, that is what is needed. We now live in a world that is supply rich. The next level questions are about demand, especially energy in developing nations.”
Examining the supply disruptions more closely, they mostly affect OPEC members. “The U.S. sanctions are starting to bite on Iran,” noted Medlock, “and the collapse of Venezuela means that OPEC as an entity has taken a hit. Coupled with the rapid growth in U.S. oil production, OPEC’s ability to move prices has now hampered absent cooperation from other producers.”
Those realities have created an unusual situation where it is actually the Saudis who are motivated to seek the cooperation of Russia, and not the other way around. Conventional thinking holds that Russia seeks a place on the world stage, and thus has recently collaborated with OPEC.
Medlock explained that under the “Dominant Firm Theory, the U.S. sanctions have made it imperative for the Saudis to engage with Russia. One of my grad students, Peter Volkmar, is writing his thesis on that very point.”
He adds that Russia is not the same leaky, creaky oil producer that was portrayed several years ago. “Thanks to the work of new partners from the West, Russia is a better operator. It still lags the West by most metrics, but is definitely better.”
In contrast, Venezuela may be in worse shape. It is widely understood that the political and social chaos of the Maduro dictatorship has caused exports to atrophy. “Whenever recovery happens it will happen in fits and starts,” said Medlock. “Presumably some increase could come quickly, but there are real concerns about the physical infrastructure. It is aging and in need of repair, the extent of which is highly uncertain.”
Midocean Point Of Arbitrage
As all of this plays out, Medlock suggests that the simplest way to monitor the balance between the U.S. and OPEC is to follow the point of arbitrage between WTI and Brent crude. “It is now on the open water, which already shows how much things have changed. It used to be that WTI traded at a premium to Brent, and the point of arbitrage was [the pipeline and terminal hub of] Cushing, Oklahoma.”
Then, pipes were reversed to flow from Cushing to the Gulf Coast. “Brent is now trading at a premium to WTI because the point of arbitrage is now somewhere in the Atlantic.”
Reviewing the latest export data, Robert Bryce, a senior fellow at the Manhattan Institute, noted that energy companies in the U.S. upstream and downstream sent crude oil and refined products to more than 100 nations in January. Last year, LNG was shipped from the U.S. to about 30 countries, including Kuwait and the United Arab Emirates. “Beyond that, it is an open secret in Houston that Saudi Arabia is shopping for a long-term LNG supplier so they can stop burning crude to make electricity,” said Bryce. “They can get much more value exporting the oil or refining it. Selling LNG to OPEC members is like selling coal to Newcastle, or ice to Eskimos. Choose your simile. It shows how dramatically the U.S. as a major exporter has changed the fundamental structure of the global energy market.”
That, in turn, “has driven a complete rethinking of the allocation of capital,” to energy-related businesses and assets, he added. That process has been going on for quite some time, but the exclamation point was the $33-billion deal Chevron Corp. struck in April to buy Anadarko Petroleum Corp., an iconic and long-lived major independent that well predated the shale bonanza.
Consolidation may bring a note of coherence to the notoriously fractious U.S. upstream sector, but Bryce hardly anticipates lock-step discipline. “There really never has been any coherence in the sector,” he recalled. “As far back as the 1930s, the Texas Railroad Commission had to implement prorationing to bring some rationality to the industry and put some reasonable brakes on supply.”
Bryce is very clear that he “is no fan of OPEC.” That said, he added, “For all the bashing of the organization, the idea of putting some limits on supply to stabilize prices is in the long-term best interest of producers. The history of U.S. production has always been boom and bust. It took decades for producers to come around to some regulation.”
While OPEC clearly has diminished influence in the shale era, “the organization is not going away,” Bryce said. “It clearly has been weakened from its heyday in the 1970s, but it has been in business for more than half a century, and there are many reasons—internal and external—to keep it together.”
The Russian collaboration with OPEC is a different matter. “That has always been an alliance of convenience,” said Bryce. “OPEC can’t effectively control cheating on quotas within its own organization. So there is certainly no enforcement for what Russia does.”
Notably, there is no OPEC in LNG, nor is there likely to be any such thing, which is good, said Bryce. “The U.S. will soon have more LNG export capacity than any other country. And as I testified before the U.S. Senate, that is good for the U.S. balance of trade, good for the worldwide economy and good for the environment, as LNG replaces the burning of coal and crude oil to produce electricity in the Middle East and Asia.”