Oil Prices: The Drill Is Gone

The nuclear deal with Iran is not yet settled, but it definitely points to, among many other things, lower oil prices. Once sanctions lift, Iran, desperate for cash, will sell all the oil it can, increasing global supplies and likely driving down prices. This one-time supply surge will, no doubt, take a while to have its full effect, until mid-2016 in all likelihood, but thereafter, slowdowns in production elsewhere in the world, including shale and tar sands in North America, should again begin to put upward pressure on the global price of crude. At this juncture, such increases promise to be moderate.

Aside from this likely Iranian supply influx, the story on prospective oil supplies and prices lies in North America. The rest of OPEC (Organization of the Petroleum Exporting Countries) seems likely to maintain its ongoing production of 30 million barrels a day. Other sources will likely show some natural falloff from depletion. That leaves combined U.S. and Canadian production as the swing supplier. Until recently, Saudi Arabia used to play this role. Now money needs render the kingdom unable to give up revenues quite so readily as in the past. There is an irony that the role has migrated to North America. Up to the 1970s, the United States, Texas actually, had long acted as the global swing producer. The Texas Railroad Commission (TRC) used a mechanism called proration to set state output and so maintain stable global oil prices. This system was the model for the eventual cartel of OPEC. Strange that after 45 years, the role of balancer in global oil markets has come full circle.

Of course, U.S. and Canadian production are not controlled by any authoritative body like the TRC. Instead, the two nations respond to profitability considerations. Here, the picture was muddied for some months, but it is now becoming clear. When oil prices fell some 50% during the second half of 2014, there was a lot of concern that marginal shale and tar sands producers would have to shut down production or even go out of business. That did not happen. Instead, output continued to rise. According to Washington’s Energy Information Administration (EIA), U.S. domestic crude oil output jumped some 13.0%, from 8.5 million barrels a day in June 2014, when oil prices touched their highs of about $105 a barrel, to 9.6 million barrels a day in recent weeks.¹

Though these facts have led to a lot of speculation that costs actually were lower than previously thought, the continued production growth has really reflected a couple of temporary influences. For one, many U.S. drillers had drilled many wells, but otherwise had failed to complete them. Even as the number of exploratory rigs declined, these operators, having already sunk most of the cost, had every reason to go on and tap those sources even as they became less profitable. Also, the considerable debt loads burdening many smaller operations prompted them to continue production just to cover interest costs. But these were temporary influences. As they lose their force, it is reasonable to look for a falloff in shale, tar sands, and other marginal sources of production.

Certainly, the EIA projects such a falloff. It estimates that the seven key shale areas in the United States should experience a 4.5% drop in crude production by summer’s end, at least from their June levels. Major oil companies also report plans to cutback output from their more marginal sources. Royal Dutch Shell PLC and Chevron Corp., for example, have already announced the postponement or suspension of projects in Nigeria, Norway, and the Canadian Arctic, while Brazil’s state-run oil company Petrobras cut its 2020 domestic production target by 33%, to 2.8 million barrels a day. Meanwhile, conventional production from existing wells also should drop simply from depletion, by some 5–8% a year, according to industry convention. That should amount to a loss of close to 5.0 million barrels a day. Little wonder, then, that the International Energy Agency forecasts net declines in non-OPEC oil output by 2016.²

Renewed flows of Iranian oil initially will more than offset this supply shortfall, allowing prices to fall. But once the Iranians bring all they can to market and prices adjust down to account for these new supplies, the falloff in marginal production will begin to have its own effect. Oil prices should begin to rise again from their lows, probably later in 2016. Barring the kinds of geopolitical shocks that frequently play mischief with energy prices, this upward price push should remain moderate, for every additional dollar in the price of a barrel of crude will tend to renew a portion of the shale and tar sands development that has paused during this time of low prices.