Tuesday, October 18, 2016

Trimming Oil Output Won’t Keep OPEC States Afloat

American frackers have put petrostates like Saudi Arabia under serious pressure, making reform—or revolution—more likely.

By Gary Sernovitz 
The Wall Street Journal
October 18, 2016

Since late last month, when the Organization of the Petroleum Exporting Countries agreed to cut oil production for the first time in eight years, the market chatter has revolved around the bloc’s credibility. The final details of the reduction must still be worked out, leading analysts to wonder: Will the cutback actually happen? Which OPEC members will slash production, and will nonmembers such as Russia join? What does this mean for oil prices?

The answers to these questions will determine whether oil trades at $60 or $40 a barrel, or at some other price. But the deeper importance of the OPEC announcement is being drowned out by the speculation about how the market will move. The proposed cutback is a victory for American oil-field engineering, which has triumphed over OPEC members’ social engineering—with potentially perilous consequences for oil-exporting nations.

Two years ago, the strategy of OPEC members, primarily Saudi Arabia, was to increase production to defend their market share. “Why should we cut production?” the Saudi oil minister at the time, Ali al-Naimi, asked. After all, existing wells in Saudi Arabia, per industry estimates, can bring oil to the surface for $10 a barrel or less. Developing new fields in the kingdom probably can be done at oil prices of only $25 to $30 a barrel. The unfairness, to Saudi Arabia, was that growing global oversupply led OPEC to consider cutting production of low-cost barrels.

But that was the reality, thanks to the American shale revolution. The U.S. had risen in a stunningly short span to roughly 5% of the world’s production. Yet analysts in 2014 estimated that U.S. firms needed oil prices of $70 to $90 a barrel to break even—to generate profit from new wells and continue growing.

In hindsight, the Saudi swagger was based on an anachronism and a category error. The anachronism was assuming that the price of producing U.S. shale would follow the usual upward trend, with high-cost barrels eventually becoming even higher cost. It had always been thus.

But over the past two years American engineers have steadily found ways to produce more oil or gas for less. In large parts of the Permian Basin in Texas and New Mexico, the break-even point has been driven down to $40 a barrel or less. This is partly the result of negotiating down the costs of drilling and fracking, an easier task when too many rigs are chasing too few jobs. Equally important is engineering ingenuity in developing new technologies and more-effective techniques.

OPEC’s other error was thinking that break-even costs had the same consequence in every country. Whether an American shale producer needs $40 or $80 a barrel to stay in business is critical to the individual company and the industry. But it’s less important overall to the U.S., which remains a net importer of oil. For countries like Saudi Arabia, in contrast, the vital number is how much excess oil revenue the government can amass. Saudi Aramco, the state-owned oil company, has a break-even price. But so does the Kingdom of Saudi Arabia.

Oil-exporting countries have shown little flexibility in lowering their dependence on petroleum revenue to make their societies function. Suffering from a “resource curse,” oil-dependent nations usually have undiversified economies, huge percentages of the workforce in state jobs, and undemocratic governments. For generations, many of these countries have socially engineered compliant populations, using natural-resource revenue to underwrite bread, circuses, sectarianism, religious fundamentalism and proxy wars. This has worked, by and large. The rulers of these petrostates have held on to power longer than many predicted.

When Saudi Arabia and others made the strategic decision in 2014 to increase oil production and defend their share of the global market, they probably assumed that the resulting lower prices—and diminished national revenue—would be temporary. Two years later, with oil prices still around $50 a barrel, it’s no longer business as usual. In Venezuela, people are going hungry. In Saudi Arabia, the state is cutting back workers’ benefits. These are dangerous times to be the leader of a petrostate.

So OPEC members have in effect admitted defeat by announcing a desire to cut production—the first of what could become many attempts to balance the market. But they may not get the increased prices that they need. If a West Texas engineer can complete new wells profitably at today’s prices—and many already can—then American producers will react to an uptick by turning on their supply, which will act as a brake on prices. This isn’t a short-term change: RS Energy Group estimates that there are 155 billion barrels of U.S. shale oil in the ground that can be economically produced at prices below $60 apiece.

The upshot is that the rulers of petrostates may have to hope that they can maintain power with less oil revenue with which to buy political legitimacy. Or they will have to embark on radical new social engineering, transforming their disenfranchised populations, dependent on state revenue, into dynamic, entrepreneurial, free people.

If the question is whether American shale producers can ramp up production and drive down their break-even prices faster than OPEC rulers can re-engineer their societies, I’ll put my money on the guys in Midland.

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