Why crude oil remains volatile

Crude oil prices: 2014-18

The past decade has been very tough for "energy experts", with a farcical series of really really bad calls — starting in 2008 with an oil price spike to $147/barrel and a consensus that the era of low prices was over because of a fossil fuel shortage.  Instead, the shale revolution came along in North America and, by 2014, it was widely expected to usher in a US industrial renaissance.  Instead (another bad call) prices went into a tailspin, finally crashing below $27/bbl.  The carnage included dozens of energy company bankruptcies, a recession for several industries, and thousands of job losses.

In Q1 2016 market prices tanked to $30/bbl and pundits then promised the end of the commodity's volatility.   Shale, according to many, has become the new bumper: North America can pump as much as it wants when prices are high, or as low as it wants when prices are down.  Some even predict the end of OPEC monopoly power.

That was then.  Fast forward to November 2017: US crude production did in fact exceed 10mmbpd for the first time since the 1970s.  Despite the continued growth in output, just last September Brent crawled back up to $73/bbl, before inching down when President Trump announced details of his Iran sanctions, awarding 8 countries Significant Reduction Exemptions -- basically allowing them to continue importing Iranian petroleum products.

So what the heck is happening to oil prices?  The US has already exceeded the output of Saudi Arabia (although it is still a net importer), why do we still care about the Middle East? Why are those countries still affecting our prices at the pump? How can all the experts be so wrong?  Does that mean crude will continue to be volatile forever? That American shale is no game-changer?

Let's dig deeper.

Source: US Energy Information Administration

North American shale producers are private sector

Shale producers are nimble, armed with the latest drilling technology developed only in the past 10 years.  But they're *companies*.  They are solely profit-driven, and their shareholders (as well as banks, financiers) need conviction to boost production.   In fact, it's illegal under antitrust laws for independent companies to gang up and set prices OPEC-style.  And this is an issue because....

Shale isn't really as flexible as advertised

Shale oil production, using novel technology called horizontal drilling or fracturing ("fracking"), is costly, and drillers will only produce as long as selling prices exceed costs.  Worldwide average cost of production is approx $70/bbl, meaning that at current prices, at least half(?) of American production capacity may be unprofitable.  Investors decry shale producer's overreliance of low interest rates, and they are demanding more emphasis on profitability -- which would likely lead to abandoning less economical wells, thus lowering overall production.

Furthermore, shale wells are notorious for their rapidly depleting yields: producing most of the output upfront and drying out quickly after.   The top five shale fields in the US reached a monthly decline rate of -518,000bpd in September 2017 -- that's like 5% of national production lost in just one month.  

Shale fields are rapidly declining

So producers need to continuously invest in exploration, drill lots and lots of wells, just to maintain -- let alone increase -- production levels. After a lengthy period of low prices, higher cost producers are either consolidated or driven out of the market, leaving a smaller number of survivors.  Saji Sam et al writes on Harvard Business Review:

While major oil companies plan to dramatically increase shale production in the Permian Basin in Texas and New Mexico, U.S. shale production alone is unlikely to be enough to satisfy the world’s growing oil needs—especially when oil reserves in shale may only get us another 10 years of oil and not necessarily 50. Oil companies will need to develop both new conventional and unconventional crude oil resources to keep up with current demand for roughly one million more barrels of oil every year in addition to replacing the approximately four million barrels lost annually as reservoirs are naturally depleted. In total, we estimate that the oil and gas industry will have to replace about 40% of today’s oil production over the next seven to nine years. 

That means difficult decisions lie ahead for independent shale producers, national oil companies, and the major integrated companies. While they can start to tap into the global reserves of shale oil, which exist literally everywhere, developing the reserves in most places from China to Argentina will require a significant investment to develop the shale ecosystem and supply chains needed, in addition to the infrastructure to gather, treat, transport, and store the crude oil. Or they can develop conventional reservoirs where it will require long-term investments in new technologies to bring the cycle times and costs more in line with those of nimble shale producers. Most major producers with large balance sheets will likely hedge their bets and attempt both.

Most recently, even shale shows that it is not immune to low prices.  Fracking activity in the massive Permian Basin shows gradual deceleration throughout H2 2018.  “Looking at preliminary data for November, we see evidence that seasonal activity deceleration has likely started in all major plays except Eagle Ford. There has been a considerable slowdown in Bakken and Niobrara in November, our analysis shows," according to research by Rystad Energy.  The report notes that a lot of shale drillers are not profitable with oil prices below US$50/barrel; breakeven prices on the very best wells can run ~ US$30-40s per barrel, but industry-wide all-in costs translate into much higher breakeven thresholds. The rig count has also plateaued after growing sharply in H1 2018.

Saudi Arabia still holds the key 

Policy still matters.  Washington has always been ambivalent about its policy goals, whether it is energy independence or energy security, as we saw in 2007 when George W Bush signed into law the "Energy Independence and Security Act".   Well if the goal is energy independence, i.e. favoring domestic supply or imports from NorAm or European countries over Middle Eastern, the US is well on its way.  But if it's energy security, i.e. guaranteeing secure supplies at stable (=low) prices despite their origins, then it's unclear if the shale revolution is net positive or net negative towards that goal.  In recent history, policymakers have lamented the country's reliance on imported oil, while constantly bowing down to consumers' pressure and demand for cheap energy.

Furthermore, the supply-demand dynamics of oil is different from those of other commodities.  The direction of crude prices is not dependent on the amount of total production; instead it depends on the marginal producer i.e. whoever can raise or cut its output on short notice.  US and Canada are not marginal producers, because their output trends are highly predictable.

In the meantime, the Russia, Saudi and other OPEC national oil companies (NOCs) are willing to put other considerations above mere financial profits.  King Salman and Vladimir Putin (their two countries are more aligned now than ever) on their own can drive prices, increasing or decreasing production on a short lead time because of their less cumbersome traditional vertical wells.  Riyadh in particular has a lot of influence, as it is the de facto leader of OPEC and has the largest share out of the global slack capacity estimated at 2mmbpd.  More and more lately, Saudi (the country) gets credit for anything good in the oil world, while OPEC (the faceless organization) becomes a convenient enemy to be blamed for anything negative (e.g. high prices).

So beyond the economics, geopolitics becomes the important issue affecting oil prices.  Keith Johnson of Foreign Policy writes:

The United States currently produces 11.4 million barrels per day, with forecasts of more than 12 million barrels a day next year. Since the beginning of the shale boom a decade ago, the United States has essentially discovered the resource equivalent of another Iran and a Kuwait trapped in Texas and North Dakota shale formations. 

But none of that makes the United States immune to oil-price shocks or able to impose its will on other countries—or even able to add many arrows to its geopolitical quiver. Regardless of how much oil America produces, it’s still a global oil market. That means that prices for gasoline in the United States are largely determined by what happens with the other almost 90 million barrels of oil produced and consumed every day around the world. [...] 

The biggest reality check for policymakers bewitched by America’s record levels of oil production is that sheer size doesn’t matter that much. Saudi Arabia produces less oil every day than the United States, but it plays an immeasurably bigger role in the world oil market than America does or ever will. That’s because Saudi Arabia has most of the world’s spare production capacity, millions of barrels of oil that can quickly be brought on line (or shut down) as the government orders to keep prices around an elusive Goldilocks level. 

That ability to open or close the oil spigot on demand is “real leverage,” said Bordoff, who was a White House energy advisor in the Obama administration. “And that’s not something the United States has, or likely ever will. Real influence stems not just from how much you produce, but from the ability to quickly add or subtract supplies, and really that is only Saudi Arabia.” 

And no matter how much oil the U.S. pumps, that gusher alone won’t free the United States from involvement in the Middle East.  Decades ago, the United States was interested in keeping stability in Saudi Arabia and the Persian Gulf region both as a source of oil imports for itself and as a lubricant for the global economy. While America imports much less Persian Gulf oil than it ever did, it is still heavily invested in defending Saudi Arabia and other Gulf states, limiting instability in big oil-producing countries, and protecting critical sea lanes such as the Strait of Hormuz. 

“Shale oil means that U.S. dependence on imports is now much less, but an increase in gasoline prices [from a Saudi supply shock] would be very unpopular. So we have to work toward a deal with the Saudis,” Henderson said, even if it means swallowing the story that dissident journalist Jamal Khashoggi’s killing was not authorized by Saudi Crown Prince Mohammed bin Salman.