By Paul Gregory, Professor, Department of Economics
Energy producers and OPEC ministers, meeting at CERAWeek in Houston, grappled with a global glut of oil that was not supposed to be. Back in November, OPEC and non-OPEC oil producers agreed to their first production cut in eight years. Thus ended a Saudi-led experiment with free markets that had driven down crude prices to historic lows. The Saudi gamble was that low prices would dry up U.S. shale investment, rig counts, and hence crude production, that competes with OPEC and Russian output.
The experiment apparently failed.
Meeting in Houston with $50 plus crude, the OPEC team, represented by the Saudi oil minister, Khalid Al-Falih, and Russia’s energy minister, Alexander Novak, grudgingly acknowledged being caught off guard by a second wave of U.S. shale production at prices they had thought would throttle the shale industry. The production quotas orchestrated by OPEC and Russia were supposed to stabilize prices below production costs of shale producers and drive them from the market. To everyone’s surprise, shale producers had used technological advances and short start-up times to push down break-even costs, below $50 in the Permian Basin.
Even the shale oil producers themselves were surprised by the speed of recovery. U.S. crude output rose to nine million barrels a day, and the global glut as expressed by rising crude inventories refused to go away, despite OPEC actions.
The OPEC-Russia coalition apparently did not anticipate that they were facing a new type of competition, one that could respond quickly and innovate to plumb the depths of cost economies.
The OPEC-Russia production cuts had been scheduled to last a half year, and they appear to have been implemented. With crude prices falling and inventories rising, OPEC – mainly Saudi Arabia – must decide whether to extend the cuts, even though the first set of cuts did not work out as planned.
The Saudi minister’s comments in Houston must have sent a chill down the spine of his Russian counterpart, as he announced that Saudi Arabia will not “bear the burden of free riders.” He also warned U.S. producers that it would be “wishful thinking” to expect Saudi Arabia and OPEC to “underwrite the investments of others [US shale producers] at our expense” through production cuts. Don’t expect us to keep prices so high that your investments are safe and you are freed from the pressure to push down costs to stay in business.
Translated, the Saudi minister warned his fellow OPEC members and Russia that Saudi Arabia is not prepared to cut its own production, which it can pump at low breakeven costs, to keep prices up for high-cost “free riders,” such as Russia. Russia, with its depleting reserves, antiquated technology, isolation from Western capital and technology, and Petrostate dependence on oil revenues must learn to live with $50 (or below) oil.
Energy producers from the Middle East. Latin American, Africa and North America must come to the realization that the energy market has reconstituted itself, with the U.S. as the swing producer. U.S. breakeven costs on unconventional oil will henceforth determine the long-run price of crude. Over the next decade, there will be fluctuations in crude prices as world demand fluctuates and political disruptions interrupt supplies, but the price should tend towards the equilibrium set by marginal costs in the U.S.
Two further factors could push the price even lower. The United States has elected a pro-energy president, who will lessen environmental and other regulations on energy production. These steps will drive break even cost even lower. If Europe and other countries follow the United States’ political changes, restrictions on unconventional oil would begin to disappear worldwide. If so, the world economy can look forward to cheap energy for decades to come.
In the meantime, Russia’s Putin will be on the outside looking in. The Russian economy and state have survived two plus years by tapping foreign reserves and depressing living standards. It is unclear how it could survive decades of energy prices below what Russia needs to stabilize its economy and provide the government with the funds it needs to maintain political harmony while fighting its hybrid wars abroad.
Paul Gregory is a professor of economics at the University of Houston. He currently teaches a course on comparative economic systems.
Gregory has published several articles in scholarly journals, in both Russian and English, and is an expert in Soviet economics and transition economics. His current research, funded by the National Science Foundation, is on the topic “High-Level Decision Making in the Soviet Administrative Planned Economy: Evidence from Soviet State and Party Archives.”
In the past, Gregory was involved in several funded economics research projects, and has earned multiple awards and honors, including the Fulbright Fellowship.
Gregory earned his bachelor’s in economics and master’s in Russian in economics from Oklahoma University, and his PhD in economics from Harvard University.