An Oil Market Experiment

A large number of commentaries have characterized the current oil market decline, down more than 40 percent since June, as a sort of stand-off between Middle Eastern oil producers and the tight oil producers in the United States. Straight forward juxtapositions like the Economist’s “Sheikhs versus Shales” portrayal are tempting both for their simplicity and the ever popular United States versus the Middle East dynamic they perpetuate. What’s happening right now in oil markets, however, is actually more complicated and at least as fascinating. We are, in fact, in the midst of an oil market experiment – one that puts to the test a number of new, large, structural dynamics in the market. Anyone who follows oil markets day-to-day appreciates the amount of learning that will take place in the coming months as a result of lower prices over a sustained period. Here are some of the issues being tested:

1)    Price responsiveness of U.S. tight oil production – One of the main questions at play is what happens to tight oil production in the United States at lower price levels over various periods of time. The short answer is—nobody knows for certain. Most analysts seem to believe that it would take a $50 price level over a period of several months to stop the growth in tight oil production. There is far less certainty about the pace and scale of a production slow down at higher price thresholds. The uncertainty derives from the heterogeneous nature of production—resources, producers, and development strategies for the plays vary widely across the country.  Some producers can weather lower prices for a longer period of time for a variety of reasons, some plays are far more economic than others, and some producers can choose to invest in other projects if return on shale is not as attractive. Everyone has a theory about the price responsiveness of tight oil but the current price environment will actually put those theories to the test.

2)    OPEC coherence – It is widely understood that OPEC’s market strength lies in the ability of its members to control their own production – increasing or decreasing supplies in order to respond to market conditions. The ability to respond to oil market dynamics means producers need to have spare production capacity that can be turned off or on within a  meaningful timeframe. Only Saudi Arabia has this capacity in large volume, which means the burden of market relevance has fallen to them. While many other OPEC members have suggested production cuts, few if any of the nations advocating cuts are in a position or willing to contribute to cuts themselves.  Countries like Venezuela, Nigeria, Iran, and Iraq all desperately need the revenue derived from oil sales due to the outsized role it plays in their economies and their failure to plan for a rainy day (or in the case of Iran and Iraq, a fairly long stretch of rainy days with no end in sight). Whether OPEC can truly be a coherent and effective group absent Saudi Arabia shouldering the entire burden is a relevant question. Perhaps a period of sustained lower prices will pressure some OPEC members evaluate their contribution to the group.

3)    Chinese demand responsiveness – Oil market demand in developed economies is waning due to lower growth, greater efficiency and several other factors. As a result developed economies like the United States and Europe and much less price sensitive than they once were. This means that markets look to large and rapidly growing countries, China in particular, as sources of oil demand growth and price support. It is much harder to predict oil demand price responsiveness in China both because the data are much more opaque, the role of oil in the economy is still shifting, demand growth has so far been correlated more to GDP than oil price, and the economic outlook for China in the near and longer term is extremely uncertain and seen as underperforming in recent times.  One of the most important parts of this oil market experiment is to understand how Chinese oil demand responds to these various price thresholds.

4)    Competition for market share – U.S. tight oil producers are not the only target to warding off the threat of a long-term oversupplied oil market. The potential for low cost producers like Iraq, most immediately, and Iran or Russia should their sanctions situations abate, and other major producers to capture more of the limited market share of oil demand growth in Asia. This competition is playing out in a competitive price cutting exercise among Middle East producers but the experimentation here is about what it will take to successfully defend market share in this and other markets and what is the breaking point between defending prices, defending market share, and other domestic resources (gas that comes with oil production) and revenue needs.

5)    Impact on gas production and trade – Before the U.S. oil boom the U.S. supply resurgence was characterized by a surge in natural gas production. Now approximately one fifth of U.S. gas production is associated with oil production and the competition for investment dollars in the U.S. upstream has been skewed towards oil or oil rich gas plays. Gas production in the United States will be impacted by the new price threshold in ways not yet fully understood. Gas economics will also be impacted in places where prices are still linked to oil which could eventually dampen the desire to delink the two prices in contracts or at least change the economic competitiveness of various gas resources in various places, perhaps most notably Europe.

There are myriad additional questions on possible impacts – what impact with this have on the trajectory and effectiveness of sanctions regimes and the crises they are put in place to help resolve, what impact will they have on those renewable energy resources that compete with oil, what are the possible impacts in the investor community and oil market volatility in general, what impact will low prices have on already unstable oil producers, and what impact will sustained low prices have on U.S. oil and gas policy specifically the barrier to crude oil exports.  By oversimplifying the complex dynamics at play right now the danger is to misunderstand major oil market participant motivations and miss some of the important learning going on that will inform future decisions - it is premature to assume a long-term strategic shift.  The most important factors in this time of experimentation, testing both markets and motivations, are how low prices will go and how long it will last – but also what happens when prices rise again.

Sarah O. Ladislaw, is the director of the Energy and National Security program at the Center for Strategic and International Studies (CSIS) in Washington D.C.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

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