Deal-breaker: Why the United States must use innovation to compete in the global oil market

By Joniel Cha

When oil prices plunged unexpectedly in late 2014, the Organization of the Petroleum Exporting Countries (OPEC) members gathered in Vienna, Austria to assess the damage on their revenue streams. They decided to let the prices keep falling, despite the fact that doing so would hurt member countries. However, the cartel’s leaders believed this would cause serious harm to upstart U.S. producers even more. They reasoned that the costs of hydraulic fracturing were too high and as the prices fell, U.S. influence on global oil prices would diminish. In response, U.S. frackers have improved their technology and reduced production costs.

In November 2016, Saudi Arabia coordinated with OPEC and several non-OPEC members, including Russia, to reach a deal and reduce their combined production of oil by 1.8 million barrels per day, pushing oil prices to $50 a barrel. This move aimed to drive out U.S. frackers from the oil market as Saudi Arabia worries that the United States will soon become a significant oil supplier, and consequently a threat to the Kingdom’s position in the market.

While there is no clear evidence of Saudi Arabia maneuvering the oil supply to block U.S. oil exports, the Kingdom’s actions indicate this. Especially significant is the fact that Saudi Arabia has opted to not intervene, which historically it had done so in the past. Further, Saudi Arabia called upon OPEC and even non-OPEC members, most notably Russia, to curb oil production so as to allow oil prices to continue to fall.

Saudi Arabia has been successful thus far in its attempts to displace the U.S. oil industry from the global market, especially since the Kingdom refrained from fulfilling its traditional role as a swing producer, which would result in oil prices to decrease. By forcing oil prices to fall lower, to the point where the U.S. oil industry can no longer afford to produce, Saudi Arabia will effectively push the United States out of the global market. The bottom line: Saudi Arabia has deliberately worked to keep the oil prices lower with the aims of preserving its market share and leading OPEC to cast out U.S. shale production by allowing prices to plunge.

As OPEC members and Russia seek to maintain their shares without the threat of U.S. oil companies infringing upon the market, President Donald Trump pushes the United States toward oil self-reliance and even extend its reach in oil exports. More players in the oil market benefit the consumers, who enjoy lower prices and greater supplies of oil.

If the United States hopes to succeed in securing its share in the global oil market, the U.S. government should incentivize oil companies to reduce production costs. In response to the Saudi-Russia deal, the U.S. government should encourage greater development of oil rigs and incentivize companies to cut costs of production. Due to falling oil prices, the United States faces smaller profits in oil production. Although frackers initially faced steep production costs and many incomplete oil rigs and wells (DUCs), they rose to the challenge. Challenges, after all, spark creativity and opportunity. U.S. producers have solved the oil crisis by utilizing their comparative advantage in innovation to improve fracking methods and produce cost-effective technologies. As a result of their accomplishments, the International Energy Agency’s World Energy Outlook 2017 projects the United States to become a net oil exporter by 2030.

Meanwhile, the Saudi government should continue to press for OPEC to reduce oil production and incentivize OPEC and non-OPEC members not to cheat. Oil-rich Saudi Arabia, which bears the brunt of the oil reduction burden, anticipates driving out U.S. competition from the oil market. In light of growing trends of U.S. penetration into the global oil market, however, Saudi Arabia should strike a deal with the United States. This will ensure a smooth transition for the United States to enlarge its share of the market, while allowing Saudi Arabia time and leverage to maintain its market share.

Russia should continue to temporarily cut oil production so as to remove U.S. competition from the oil market. Russia must also support Saudi Arabia to enforce OPEC and non-OPEC members bound to the deal not to cheat. Due to the apparent success of the Saudi-Russia deal, Russia has extended it into spring 2018. Meanwhile, Russia also focuses on maintaining its dominance in the gas market, building pipelines into Europe and China, and expanding liquefied natural gas capacity for South and East Asia.

OPEC members and non-OPEC oil producers recognize incentives to cheat so as to increase production of oil and generate profits while the rest of the countries abide by the deal and suffer for it. Because of economic downturn and government expenditure in Syria and Ukraine, the Russian government may resort to increasing oil production in order to compensate for its spending. Despite Russia’s reputation for cheating by ramping up oil production, it also seeks to strengthen relations with Saudi Arabia and the Middle East region.

Moreover, OPEC members will most likely cheat as they have historically done. Some members may overproduce their quotas, but OPEC will monitor global crude inventories. Those inventories have already begun to come down from record highs prior to the OPEC announcement, partly in response to declining U.S. shale oil production. However, OPEC complied with the cuts in January 2017 at 82 percent. Crude oil shipments from OPEC countries fell by 900,000 barrels per day in January 2017, indicating that substantial cuts have indeed taken place.

U.S. shale oil producers will ramp up production as oil prices rise, negating the OPEC cuts. Yet, between 2000-2008, U.S. oil rigs doubled from 200 to 400, but U.S. oil production hardly responded. Shale wells have an initial burst of production, followed by a decline of as much as 80 percent in the first year after they are drilled. There exists an uptick in well completions over the past year in four oil-dominant regions in the United States: Bakken, Eagle Ford, Niobrar, and Permian Basin – 4,509 wells in December 2016. The United States must offset OPEC’s reduction of 1.8 million barrels per day if it wants to cover fracking cost overruns.

Oil prices hit the highest they have been the past three years in January 2018. This is prompted in part by strong demand, geopolitical risks, a weaker U.S. dollar, and efforts by OPEC to curtail supply. The price hike has motivated U.S. shale producers to increase production, which can eventually lower the price of oil. Concerns about mounting U.S. crude production also weigh on oil prices. Resource Economist Ltd. predicts U.S. oil production to rise. Brokerage PVM Oil Associates Ltd. and the International Energy Agency go a couple steps further and anticipate the U.S. output to approach and surpass 10 million barrels a day, outpacing Saudi Arabia later this year – which has not happened since 1970. Now the dreaded onslaught of oversupply from four years ago rears its ugly face before OPEC yet again. Namely, the re-emergence of the problem that OPEC was initially attempting to solve: the problem of the oil glut in the global market and pending oil prices to fall.

A major player left out of the discussion is China. China overtook the United States as the world’s leading oil importer in 2017, and its import dependency will continue to rise as shale production increases. Rosneft, Russia’s state-owned oil giant, and CNPC, China’s state-owned enterprise, signed deals effectively displacing Saudi Arabia and ensuring Russia as China’s prominent oil supplier. Meanwhile, India, Malaysia, and Indonesia also seek to expand their export capacities.

Saudi Arabia and Russia compete for energy dominance in the Asia Pacific. At the same time, though, Saudi Arabia and Russia are exploring joint ventures with LNG capacity, and embarking on projects not only in the Asia Pacific but also in the Arctic.

Yet shale is changing the game. The United States exported virtually no oil to China in January 2017. This January 2018, however, it exported 400,000 barrels per day. Rystad Energy thinks that U.S. oil production could outpace both Saudi Arabia and Russia by the end of 2018. The IEA claims that everything is in perfect alignment for continued fast U.S. growth: rising prices in parallel to additional drilling, completions, production, and hedging.

Joniel Cha is a M.A. Candidate studying International Economics and Energy, Resources, & Environment at Johns Hopkins University School of Advanced International Studies (SAIS), Washington, DC. He is a graduate of University of Virginia.