The New Paradigm in Oil

27th April 2015

An April 22nd article in the New York Times entitled “New Balance of Power” details the waning influence of OPEC on world oil prices and the rising primacy of market forces, declaring that “the United States is overtaking the Organization of the Petroleum Exporting Countries as the vital global swing producer that determines prices.” This is creating a new paradigm in which global oil prices are likely to settle into a long-term equilibrium of $70-80, driven by supply/demand dynamics rather than by “overt manipulation” by OPEC.

The paradigm seemed to shift on November 27th, 2014, when OPEC chose not to slash production, their traditional response to falling oil prices (in the $70 range at the time, down from $100 in July). Afraid of losing market share to the United States, OPEC production was maintained. The hope was that US shale producers would cry uncle as prices dropped and cut production, eventually driving oil back up. This decision shocked the market, and prices plunged to the mid-$40 range.

In the ensuing months, US producers have proven to be more nimble and resilient than OPEC anticipated. The number of oil rigs has been cut by half to about 800 in April (at the cost of 100,000 jobs). Lower prices have forced drilling and other oil service companies to lower costs by more than 15%. Meanwhile, the industry is consolidating, strengthening the remaining players. And the hydraulic fracturing technology that has driven the US boom continues to improve, further lowering costs and increasing yields. All of this is bad news for OPEC, used to controlling the spigot. Now shale producers can be not only more reactive than ever before to changing supply/demand dynamics, they can also flourish in a lower-price environment.

Experts in the space seem to think that oil prices will eventually settle into a supply- and demand-driven equilibrium of $70-80 per barrel, although this could take a year or more. In the short term, US producers may feel more pain as oil languishes in the $50 range (while drivers continue to rejoice). But the economics of shale have changed the game: in the longer term, consumers and producers in the rest of the world are set to benefit as OPEC’s manipulative grip on oil prices is replaced by the market’s invisible hand. The ride to equilibrium may be bumpy, though, so savvy investors who understand this new paradigm may be well-positioned to take advantage of dislocations (like in energy credit markets right now) that crop up along the way.