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December 28, 2016

How the Oil Price War Made U.S. Producers Even Stronger

December 28, 2016
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OPEC, the cartel of oil producing countries, for years has been able to manipulate oil prices on the world market by controlling its level of oil output and oil exports. In 2008, oil prices hit a high of over $150 a barrel, which quickly prompted increased development of U.S. shale oil deposits. The renaissance that ensued from the use of hydraulic fracturing to produce oil in the United States resulted in an oversupply of oil on the market and helped to bring oil prices crashing down in the summer of 2014. OPEC thought its best strategy was to maintain market share, keep the price of oil low, and force the U.S. shale oil producers into oblivion. But, that did not happen. U.S. producers used their ingenuity to reduce operating costs and increase productivity enabling them to produce at lower cost. Now, OPEC realizes it must cut production to raise oil prices—much needed to keep their economies flourishing and their debt contained. Whether the production cuts, which go into effect on January 1, 2017, will have a lasting impact is yet to be seen.

Falling Cost of U.S. Shale Oil Production

In shale oil fields from Texas to North Dakota, production costs have roughly halved since 2014, when Saudi Arabia turned toward maintaining OPEC’s market share in an attempt to drive higher-cost shale producers out of the market. But, instead of killing the U.S. shale oil industry, the price war that ensued made shale oil a stronger rival. For example, in Dunn County, North Dakota, there are about 2,000 square miles where the cost to produce Bakken shale oil is $15 a barrel, which is about the same as Iran’s cost, and a little higher than that of Iraq. Dunn County produces about a fifth of the daily production in the state—about 200,000 barrels of oil a day. Improved technology and drilling techniques have boosted efficiency for the entire state and U.S. oil industry. On average, the breakeven cost per barrel to produce Bakken shale oil at the wellhead has fallen to $29.44 a barrel in 2016 from $59.03 a barrel in 2014. (See chart below.)[i]

Source: http://www.reuters.com/article/us-opec-meeting-usa-shale-idUSKBN13P0C8

The production costs of producing oil from shale oil basins in the United States are becoming competitive with Middle Eastern oil field costs as the chart below shows.

Source: http://www.reuters.com/article/us-opec-meeting-usa-shale-idUSKBN13P0C8

Bakken shale oil producers still need a substantially higher price than their breakeven cost to make a profit since they pay more to transport crude to market than producers in most other U.S. oil producing regions due to its distance from markets and the higher cost of rail shipments over pipeline shipments. International oil prices of $45 a barrel are enough for some Bakken producers to profit, while $55 a barrel would encourage production growth.

OPEC Agrees to Cut Production

OPEC has agreed to cut oil output by about 1.2 million barrels a day starting in January, reducing its combined production to 32.5 million barrels a day. The agreement exempted Nigeria and Libya, but gave Iraq its first quotas since the 1990s. Saudi Arabia will reduce output by 486,000 barrels a day to 10.058 million barrels a day and Iraq, OPEC’s second-largest producer, will cut production by 210,000 barrels a day. The United Arab Emirates and Kuwait will reduce output by 139,000 barrels a day and 131,000 a day, respectively. Non-OPEC members have agreed to cut production by 580,000 barrels per day, with Russia agreeing to cut by as much as 300,000 barrels a day “conditional on its technical abilities.”

The strength of the deal will depend on whether all parties adhere to their commitments. Saudi Arabia, the U.A.E. and Kuwait, have traditionally implemented their cuts, but some other OPEC members have not.[ii] The last two years have been painful for OPEC, earning $341 billion from oil exports this year, down from a record $920 billion in 2012—a loss of over 60 percent in 4 years.

OPEC’s announcement of the pending cuts has increased the price of crude oil. Brent crude oil is averaging around $55 a barrel. The increased price of oil has increased gasoline prices, which are now averaging over $2.20 a gallon for regular. As a rule of thumb, an increase of $10 a barrel for oil will increase gasoline prices by about $0.25 per gallon.

Whether oil prices will increase further depends on whether the production cuts are adhered to. How long they remain at higher levels will depend on how quickly U.S. oil producers can increase their production spurred by higher prices. On average, U.S. oil production is down about 850,000 barrels per day from the same time last year. Hydraulic fracturing is used to produce about half of the oil currently produced in the United States as the chart below shows.

Source: http://www.eia.gov/todayinenergy/detail.php?id=29252

OPEC Cuts Bring Opportunities to U.S. Producers

At the end of last year, the United States lifted a 40-year old ban on exporting U.S. crude oil. Since then, the U.S.’s non-Canadian oil exports have mainly gone to Europe. OPEC’s production cuts may open an opportunity for U.S. oil exports in Asia—a growing market. The more efficient drilling methods noted above may help U.S. producers to compete on price with OPEC producers.[iii] Some analysts believe the production cuts will lead to lower tanker rates and rising spreads between the U.S. benchmark crude and the Brent or Dubai crude prices. Estimates of tanker costs for next year show that a supertanker with capacity of 2 million barrels would earn an average of $25,000 a day–12 percent less than before OPEC pledged to cut production.[iv]

The U.S. is already exporting crude oil to Asian markets. Data from the Energy Information Administration show that U.S. crude oil exports reached a record-high in September of 692,000 barrels per day. In that month, exports to Singapore, for example, reached 99,000 barrels per day from 21,000 barrels per day in August and exports to South Korea were 59,000 barrels per day.

Conclusion

Oil markets have historically had their ups and downs. Despite many U.S. producers having to file for bankruptcy and many oil workers losing their jobs over the past two years as OPEC determined to maintain market share, U.S. producers used their ingenuity to slash production costs and improve productivity. Now, OPEC is planning to cut production, which has increased the price of crude oil and gasoline. Whether the production cuts will be maintained and prices will increase even more will likely be determined over the next six months.


[i] Reuters, Leaner and Meaner: U.S. shale greater threat to OPEC after oil price war, November 30, 2016, http://www.reuters.com/article/us-opec-meeting-usa-shale-idUSKBN13P0C8

[ii] Bloomberg, OPEC Confounds Skeptics, Agrees to First Oil Cuts in 8 Years, November 30, 2016, https://www.bloomberg.com/news/articles/2016-11-30/opec-agrees-to-cut-output-by-1-2-million-barrels-a-day

[iii] CNBC, OPEC just created a big opportunity for US oil companies: Exports to Asia, December 9, 2016, http://www.cnbc.com/2016/12/09/opec-output-cuts-make-us-exports-to-asia-possible.html

[iv] Oil Price, A Unique Opportunity: OPEC Cuts To Boost U.S. Shale Exports, December 14, 2016, http://oilprice.com/Energy/Crude-Oil/A-Unique-Opportunity-OPEC-Cuts-To-Boost-US-Shale-Exports.html

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