Early last Fall, when oil prices had fallen by about $25 a barrel and it became clear the decline was more than a temporary blip, the big question was how far prices would fall. And that would depend on whether and when Saudi Arabia and its OPEC partners would support the world oil price by cutting their own production. By this winter, we had an answer. The Saudis have made it clear, by what they have said and what they have not done, that they want the U.S. and others to cut production before they do any cutting of their own. This is the end of the Organization of the Petroleum Exporting Countries as we have known it, and it will keep the global oil market chaotic for some time.
On Tuesday, oil prices fell further after the United Arab Emirates’ oil minister said OPEC would keep output unchanged. Markets will adjust to this new situation, but not very quickly. And most of the adjustments will have to come from lower oil production because consumption depends largely on the level of fuel efficiency of today’s vehicles and planes, and that’s unlikely to change anytime soon. Thus, most of the adjustment will have to come from the supply side of the market, where low prices could force some high cost fields to shut down earlier than planned and cause many new drilling projects to be abandoned.
Most of the world’s new oil production has come from U.S. shale fields and Canadian tar sands — two main forms of “tight oil” that were made possible by new technologies that had revolutionized the industry. Both are relatively high-cost sources of oil, but with an important difference. The tar sands projects require huge initial investments in processing plants but have low marginal costs to operate afterward. Once established, their production is unlikely to change much. By contrast, shale fields produce most of their output in the first year, which makes their output highly responsive to oil prices. A disproportionate amount of any reduction in global supply is therefore likely to come from cuts in U.S. shale oil production.
That adjustment is already underway, and it will lower the projected path of oil production for later this year and beyond. But in the immediate future, U.S. production will continue to grow as wells started last year are completed. For now, production will continue to exceed demand and inventories of oil and oil products, which are already at historically high levels, will rise further. So it is easy to make the case that prices are headed still lower in the near term.
Looking a few quarters ahead, the prospects begin to change. On the demand side, lower oil prices will weaken the incentives for a more fuel efficient capital stock. The high fuel prices of the past several years had moved the airlines to order more fuel-efficient planes and tilted consumers to more fuel-efficient cars. But by late last year, airlines were cancelling new plane orders and car sales of SUVs and light trucks soared. These effects will be modest. They will not undue the environmental movement toward fuel efficiency, but will delay some change. Barring some unexpected disruption in supplies from noneconomic developments, the main adjustment to the imbalance in the global oil market will have to come from cuts in the world’s oil production. Prices should recover from this winter’s slide, which reflect the continuing increase in North American production. But to discourage enough high-cost production for the longer run will require prices to stay substantially below the $100 level that prevailed through last summer.
If prices stay low, the implications on the world economy and geopolitics will be large and diverse, even if, over the next several years, oil prices recover from present levels to the $60 to $70 a barrel range, that would still maintain a decline of well over $1 trillion a year from last summer’s level of oil revenues – and oil users’ costs.
Some of the effects are welcome, others not. For Russia, whose budget depends heavily on oil revenues, the decline in oil prices is a financial disaster. The ruble’s foreign exchange value has already been cut in half. Terrorists in the Middle East arm themselves with revenue from oil. In the U.S., the development of shale fields has often been funded with credits that are held by banks and high-yield bond funds. Many of these credits could default. Alongside these complications, some of which are good and some not, the unambiguous positive effect of lower oil prices will be for the boost they provide to the purchasing power of the world’s consumers at a time when such stimulus is badly needed.
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