In its January Oil Market Report, the International Energy Agency (IEA) predicts “explosive” growth in U.S. oil production, in reaction to rising oil prices. In a recent congressional hearing, Fatih Birol, Executive Director of the IEA, described the United States as “the undisputed oil and gas leader in the world over the next several decades.” U.S. production is forecast to exceed 10 million barrels per day in 2018, surpassing Saudi Arabia and behind only Russia.
This incredible surge in production begs the question—is the United States taking on Saudi Arabia’s role in the oil market? It’s an interesting question, and certainly one that the current administration raises with its emphasis on “energy dominance.” But the answer is no—the U.S. industry will never play a similar role to Saudi Arabia’s in the oil market, no matter how much U.S. oil production grows. To understand why, it’s helpful to consider recent oil market events.
OPEC pulls back supply to boost prices, but to what end?
After oil prices reached more than $110 per barrel in 2014, the benchmark Brent crude oil price collapsed to as little as $30 per barrel in early 2016. In response, OPEC combined with Russia to decrease oil production, with the goals of increasing oil prices and decreasing oil inventories. The deal to reduce production by 1.8 million barrels per day (bbl/d) was struck in late November 2016 and has since been extended through the end of 2018. The Saudis have delivered the largest portion of the supply decrease, significantly exceeding their agreed-upon cut of 486,000 bbl/d. Since the production cuts, the oil price has risen by roughly $25 per barrel.
This result certainly looks like a success for OPEC. But given changes in the global oil market, OPEC’s overall gains are likely to be temporary.
The shale oil that dominates U.S. production growth delivers oil faster with much lower up-front costs than traditional oil and gas. This allows U.S. production to be very responsive to price swings like the one that OPEC has created in the last year. (I described this in an earlier post.) This responsive U.S. production is rapidly counteracting the OPEC production cut. In fact, the IEA forecasts that increasing U.S. oil production alone will nearly make up for the OPEC cut by the end of 2018.
The rapid increase in U.S. oil production leaves OPEC in a difficult position. OPEC has shown its ability to compel production cuts from its members and raise the oil price, but at the cost of losing market share as U.S. production has grown in response to higher prices.
This loss of market share may be even more harmful to OPEC in today’s world of energy abundance. Predicting the timing of peak oil demand is becoming a parlor game among oil economists. While nearly all agree that the world will see one to two decades of continuing oil demand growth, maintaining market share in this changing world is more important than in the past. OPEC may have won the battle to raise the oil price, but it appears to be losing the market share war.
The United States is a crucial oil producer, but not a “dominant” one.
The United States has become an important oil producer and changed the landscape of the global oil market, particularly with its ability to more quickly rebalance the market in response to price changes. But important differences between the U.S. and Saudi oil industries mean that the United States will not take over the Saudi role in global oil markets, even though it is poised to surpass Saudi Arabia in terms of production volume.
Saudi oil is all produced by a single entity—Saudi Aramco—which is owned and operated by the Saudi government. Saudi Aramco does not operate on a simple profit motive like a for-profit company. Concerns about politics and management of the global oil market influence production decisions in a way that would not occur at a company solely focused on profit. Saudi Aramco plans to sell shares equaling five percent of its value in an initial public offering (IPO) in the second half of this year, but the fundamental structure and decisionmaking at the company will remain controlled by the government.
In the United States, the oil industry is made up of dozens of companies that make individual investment and production decisions, based on their own costs, financial positions, and appetites for risk. The U.S. oil industry will never act as one to manage the market or raise prices. In fact, such behavior is illegal under anti-trust law. But this is exactly how Saudi Aramco and the other OPEC members operate—it is the very purpose of OPEC.
A related point is that all of the individual U.S. producers are price takers in the marketplace, meaning that they have no ability to influence global oil prices through their own actions. But Saudi Aramco is large enough for its production decisions to influence prices. In addition to reducing production to push prices upward, as is happening today, Saudi Arabia can rapidly increase production to deal with oil supply disruptions. Saudi Arabia is the only oil producing country with significant spare production capacity. The U.S. Energy Information Administration estimates that the Saudis keep 1.5 to 2 million bbl/d of production capacity in reserve, a strategy that would not make economic sense for a for-profit company.
This difference between price taking and price making is why describing the United States as “energy dominant” is misleading. To me, “dominance” implies an ability to move markets, whereas the U.S. industry, while strong and increasingly important to global energy security, is not structured to achieve that end.
Another important difference between Saudi oil production and that in the United States is the very low cost of producing Saudi oil. The actual costs are a close-kept secret, but we know that they are among the world’s lowest. In a world where oil demand is likely to plateau and fall over the coming decades, the Saudi oil industry is likely to remain profitable through the end of the oil era. The U.S. oil industry has achieved declining production costs through relentless competition and the discipline of lower prices. But the shale oil resources that have fueled the U.S. production boom are inherently more expensive to produce than those in Saudi Arabia.
How will the Saudis play in the new oil world?
Although the United States has become an indispensable source of oil and gas production, Saudi Aramco will continue to play a unique role in global oil markets, owing to its immense size and influence and its low production costs.
An interesting question to watch over the coming years will be how Saudi Aramco reacts to the combination of abundant supply and an end to demand growth that, although it may be many years away, is inexorably approaching. To date, the Saudis have focused on managing prices and ensuring that their reserves last well into the future. But with a potential end to demand growth, will they change their strategy to compete more strongly in the market on price, acting more like the American producers? Only time will tell.