Could current oil prices be the new normal?
True to form, no sooner have sanctions been lifted then Tehran has moved to decisively ramp up energy production, the lifeblood of its struggling economy. While it will take some months for the Islamic Republic to meet its ambitious goal of increasing oil production by 500,000 barrels per day (bpd), there is little doubt that Iran will eventually get there, further exacerbating the present over-supply of energy that has so dramatically driven world-wide prices down. In June 2014 oil stood at $120 a barrel; today the price stands at around $30 a barrel, a precipitous tumble of some 70 percent.
Iran’s latest energy gambit must be seen in the larger global context of what is going on in the world’s energy market, and especially, what is driving prices down to unheard-of levels, and what is keeping them there.
We can start and easily dispense with the important demand side of the equation. Apart from booming India, and just possibly China, increased demand simply isn’t on the cards anywhere else in the world. Muted demand would be a challenge to global oil producers, even apart from what is happening on the wild and woolly supply side.
Saudi Arabia, as the swing producer in OPEC, has forthrightly embarked upon what I call the John D. Rockefeller strategy in energy markets. To see off growing competition, especially from the US shale revolution, Riyadh has acted much as the great nineteenth century American oil tycoon so often did. Rockefeller would increase his oil production, even enduring significant medium-term economic pain for his company as a result, all to know he could drive his erstwhile competitors out of business, thereby preserving market share.
As Saudi Arabia possesses one of the world’s largest capital reserves, and as high-grade oil can be brought to market from the country more cheaply than almost anywhere, a sustained attack on medium-price producers like the emerging American shale industry makes a great deal of sense, on the surface.
As such—and despite howls of protest from far more inefficient energy producers like Venezuela—OPEC has yet to blink, maintaining production at near record levels. With tensions between Tehran and Riyadh at their highest in decades, there is virtually no chance that OPEC will agree on meaningful production cuts anytime in the near future.
But if OPEC isn’t blinking, shale isn’t wilting. Despite a sharp fall over 2015 in the number of rigs in use—due to the Saudi Rockefeller strategy—the US managed to sustain production of 9 million bpd over the course of the year. The simple reason for this is that shale drilling has become ever more efficient as engineers learn how to better work with the new technologies that surround the industry.
It is now estimated that shale drilling is still economical even when the price hits $50 a barrel, a marked improvement in its performance, if still not as economical as Saudi drilling. The other major advantage of shale is that its rigs can be turned on and off like a water tap, and are thus far more price sensitive than the fixed rigs that dominate energy production in the rest of the world.
Because of this, American production can nimbly ebb and flow. So even if the Saudis win their Rockefeller bet, and drive shale producers to cap their rigs due to the low price over time, as the price then invariably begins to rise, shale will quickly come back on-line. In essence, the shale revolution has put a permanent ceiling over oil prices.
Further, even if shale companies are driven out of business, that is no real hardship for the industry as a whole. The entire history of American wildcatting in the energy industry is about companies dramatically rising and falling, with the inherent value of oil meaning there were always corporate giants ready and eager to take their place.
In this case, there is little doubt that American hedge funds—some of whom have already evinced an interest—would step in and buy up smaller energy companies bankrupted by the Rockefeller strategy on the cheap, waiting to cash in as the price rises. American energy production is largely in private hands, which means that there is always another company ready to step into the energy market.
Conclusion: The only way is down
Given all this evidence, there is little doubt that energy prices will remain low, well into the medium term. Global demand is slowing and (barring India) there are no obvious bright spots ahead to power increased energy consumption. The Saudi’s seem sanguine about their reserve losses over the past year, and intent on pursuing their John D. Rockefeller strategy. Iran is coming back online. Shale is not wilting, and is generally proving surprisingly resurgent. All this definitively means that low oil prices are now becoming the new normal.
John Hulsman will be at Flame Conference 2016. Click here to find out more.