By Bill Gilmer, Director of Institute for Regional Forecasting, C.T. Bauer College of Business
Last fall, it seemed the end of the global oil glut was already at hand, when optimism soared after OPEC’s commitment to speed the process by limiting production. Oil prices were expected to quickly move to $55 and $60 per barrel, and then continue climbing in 2017. The rig count rose, and jobs began to return throughout the oil patch.
But it has since become another false start for oil markets. Oil prices remain mired between $45 and $50 per barrel, and price expectations – measured by the futures market for West Texas Intermediate – have fallen back to levels well below those that prevailed before the OPEC accord. The domestic rig count has peaked for now, and the big investment houses forecast a decline in domestic drilling through the second half of this year.
What happened? American fracking ran the recovery off the rails . A competitive industry that – in principle — should move oil output and price to stable long-run levels, fracking is once more living too high on large subsidies to its capital base and operating costs. This leaves oil markets locked in a destructive cycle that has again reached the stage of over-production and depressed price. It has brought us to the brink of yet another pull-back in U.S. drilling activity, and another round of financial stress for many producers.
What happened to $60 Oil?
The revolution wrought by American fracking is a technical marvel, but it also leaves the industry largely responsible for the 2014 oil bust. Figure 1 shows how horizontal drilling and hydraulic fracturing reversed 40 years of declining U.S. oil production, adding just over four million barrels per day (b/d) of new production between 2011 and 2014. This was the only source of new non-OPEC oil during this period, and flooded into a market that had averaged annual growth of only 1.3 million b/d over the previous 20 years.
The economics of the shale revolution set it well apart from conventional oil exploration and production. In contrast to the oligopolistic markets of Shell, Exxon, and the giant national oil companies, fracking looks and behaves more like a competitive industry: numerous small firms, low barriers to entry, and production that can be quickly ramped up or down in as price changes. Unlike conventional oil, there is no significant exploration risk, making output relatively certain, and working more like an assembly line. Given these properties, if the long-run equilibrium oil price is $60 per barrel – something that both the petroleum and financial engineers tell us — then producer behavior should move supply and demand into balance near that level.
The trigger for the 2014 collapse in oil prices was OPEC’s declaration that it would no longer act as swing producer, i.e., no longer withdraw oil from world markets to support price. OPEC handed that job on to American fracking, but the industry has proved messy and undisciplined in the process. U.S. production fell slowly and by nearly 900,000 b/d in response to low oil prices, but then began to rise again in late 2016. Based on drilling already performed, it should return to near record-high levels by year-end. New production was partly triggered by OPEC’s renewed efforts to rebalance oil markets last November, and partly by perverse incentives enjoyed by the fracking industry.