With oil prices strategy, OPEC takes aim at US shale

To paraphrase Mark Twain: Rumors of OPEC's demise have been greatly exaggerated.

Breathless coverage of the rise in U.S. oil production in the last few years has led some to declare that OPEC's power in the oil market is now becoming irrelevant as America supposedly moves toward energy independence. This coverage, however, has obscured the fact that almost all of that rise in production has come in the form of high-cost tight oil found in deep shale deposits.

The rather silly assumption was that oil prices would continue to hover above $100 per barrel indefinitely, making the exploitation of that tight oil profitable indefinitely. Anyone who understood the economics of this type of production and the dynamics of the oil market knew better. And now, the overhyped narrative of American oil self-sufficiency is about to take a big hit.

After weeks of speculation about the true motives behind OPEC's decision to maintain production in the face of declining world demand--which has led to a major slump in oil prices--the oil cartel explicitly stated at its most recent meeting that it is trying to destroy U.S. tight oil production by making it unprofitable.

One of the things a cartel can do--if it controls enough market share--is destroy competition through a price war. Somehow the public and policymakers got fixated on OPEC's ability to restrict production in order to raise prices and forgot about its ability to flood the world market with oil and not just stabilize prices, but cause them to crash.

The industry claims that most U.S. tight oil plays are profitable below $80. And, drillers say they are driving production costs down and can weather lower prices. OPEC's move will now test these statements. The current American benchmark futures price of about $65 per barrel suggests that OPEC took into consideration the breakeven points cited in the linked article above.

It is largely Saudi Arabia which enables OPEC to have production flexibility since the kingdom maintains significant spare capacity, declared to be in the range of 1.5 to 2 million barrels per day (mbpd). OPEC says in its "World Oil Outlook 2014" that all of OPEC has about 4 mbpd of spare capacity, though one analyst recently put the number at 3.3 mbpd.

Whatever the precise number, in practical terms Saudi Arabia is the Walmart of world oil markets, able to affect a price drop at the turn of a few valves or through failure to turn them off in the face of falling demand. In this case, the country did not turn off any of its production in response to weakening world demand. Nor did other OPEC members. Having twisted enough arms in the most recent OPEC meeting, Saudi Arabia got its way with a commitment from OPEC members to hold production steady, thus putting further pressure on the oil price in the wake of falling demand.Both of the world's major oil futures contracts fell by 7 percent after the announcement.

The effect has been far greater in North Dakota than the ongoing drop in futures prices would indicate. That state, which is at the center of the U.S. tight oil boom, is far from refineries and pipelines. Oil producers use expensive rail transport to carry their oil to market. The result is that North Dakota producers face a significant discount at the wellhead. For October the average discount was $15.40 per barrel below the U.S. benchmark Light Sweet Crude futures price. If we take that discount and apply it to last Friday's close, that would imply that North Dakota producers are now receiving $50.59 per barrel--a level unlikely to be profitable except for the most prolific wells.

If prices remain that low, OPEC will almost certainly achieve its objective of preventing significant investment in new production in the state. Other major tight oil production is centered in Texas, closer to pipelines and thus not subject to discounts of this magnitude. Still, with oil around $65 per barrel, it is likely that production would rise very little in Texas in the tight oil plays, if at all. Deposits outside the "sweet spots" currently being drilled are almost certainly uneconomic at such prices.

If a prolonged low price leads to painful and permanent losses for owners of shares and bonds of the tight oil drillers--and for those invested directly in actual wells--there will be less appetite among investors to rush in even when oil prices recover. That's precisely what OPEC is counting upon. It knows that free cash flow (cash earned from operations minus capital expenditures) for independent drillers has been wildly negative since 2010. The furious drilling of the past few years has been financed largely by share issues and debt rather than earnings from previous wells.

At these new low oil prices, it's unlikely that many investors will be willing to put more money to work in the tight oil deposits of America. That will make it hard for drillers to fund new drilling since they have insufficient cash being generated by current operations. In addition, with oil prices significantly down, many independent drillers may have a hard time paying off their debts, let alone paying the costs of drilling a large number of new wells. And with yearly field production decline rates in tight oil areas of about 40 percent--which simply means that no drilling for a year would result in a 40 percent decline in production--drillers have to drill a large number of new wells just to make up for production declines in existing wells BEFORE they get to new wells that actually add to the overall rate of production. A significant drop in the rate of drilling in U.S. tight oil plays could actually result in lower overall U.S. oil production.

Lower oil prices tend to increase demand for oil as people can afford more energy for consumer and industrial purposes. So, OPEC is fully expecting demand and then prices to rise over the medium term--but not, it hopes, soon enough to bail out tight oil drillers.

All things being equal, lower oil prices tend to increase economic activity and may help Europe and Asia avoid a recession by lowering energy costs significantly. But all things may not be equal since at least one analyst believes the current rout in the oil markets could lead to cascading defaults that start with the junk bond debt of oil drillers and move through banks heavily invested in oil company debt. That, in turn, could cause a general stock market collapse. Thus, instead of promoting economic growth, low oil prices would be the cause of the next stock market crash and the next worldwide recession.

Such a recession would likely sink oil prices further, putting extreme financial pressure on OPEC members less well-endowed than Saudi Arabia. And, it would upset OPEC's timetable for a return to higher prices and profits--delaying it perhaps for years. It would also put another nail in the coffin of the American oil independence story--one that even the ever-optimistic U.S. Department of Energy never believed at high prices--by moving many of the U.S. oil plays previously considered viable into the uneconomic category.