Source: Military.con
April 1 2020
By Joseph Micallef
The oil and gas industry had a significant Achilles heel, however. Oil and gas development had significant up-front development costs but, in many cases, relatively low operating costs. Once a well was brought into production, the cost of keeping it operating was relatively low, even if the revenue was insufficient to amortize the development cost. The result was that, historically, the oil and gas industry has been subject to volatile swings in pricing.
In 1919, the Texas Railroad Commission (TRC) was charged with setting production levels among Texas oil producers in order to control the supply and stabilize prices. From 1930 through 1960, the TRC was largely responsible for setting the price of oil worldwide.
In 1960, a group of oil-producing countries, led by Saudi Arabia, adopted the TRC model and formed the Organization of Petroleum Exporting Countries (OPEC) to regulate oil production and stabilize prices. OPEC did not eliminate oil price volatility, but its willingness to regulate its production levels helped moderate some of the pricing instability. Between 2000 and 2020, average yearly oil prices varied from a low of $21.99 per barrel in 2001, to a high of $102.58 per barrel in 2011. The average price in 2019 was $57.92 per barrel. Currently, average oil prices are approximately $20 per barrel.
Canada, Russia, Norway, the United Kingdom and the United States, all significant oil producers, were among the oil-producing countries that did not join OPEC. The U.S., a major producer, began to import oil in 1959. Although the U.S. still imports oil, it has been a net exporter of both refined petroleum products and crude oil since November 2019.
OPEC's share of the global oil market peaked at slightly more than 50% in 1973. In 2019, it was approximately 30%. Energy conservation; new discoveries; improvements in drilling and production technology; and, most significantly, the development of horizontal drilling to open "tight" oil- and gas-bearing formations and the development of the Canadian tar sands, have all cut into OPEC's market share. In addition, Asia, principally China, India and Japan, have now become the main market for OPEC's exports.
In 2017, Russia, along with 10 other non-OPEC oil-producing countries, agreed to coordinate production cuts with the group in order to stabilize prices. The countries were referred to as the "Vienna Group" and the arrangement as OPEC+. The agreement represented a strategic alignment of Saudi Arabia and Russia to rationalize prices. It lasted through March 2020.
One of the immediate effects of the COVID-19 pandemic was a sharp drop of approximately one to two million barrels per day (BOPD) in world demand for petroleum. In early March, OPEC agreed to extend its current cutbacks of 2.1 million BOPD and to reduce production by an additional 1.5 BOPD to a total of 3.6 million BOPD.
OPEC requested that Russia and the other 10 oil-producing countries in the OPEC+ group decrease their production by an additional 500,000 BOPD. Russia refused to accept the additional production cuts, arguing that any production cutbacks would simply be made up by American shale oil producers.
In retaliation, Saudi Arabia declared that it would flood world oil markets in a quest to regain lost market share and indirectly punish Russia for its unwillingness to cooperate.
Within a matter of days, world oil prices cratered by approximately 60%. The collapse of oil prices, coupled with rising anxiety over the economic consequences of the growing COVID-19 pandemic, triggered widespread economic turmoil and a marked decline in financial markets.
U.S. Strategic Interests and OPEC
The governments of both Russia and Saudi Arabia are heavily dependent on petroleum exports to fund the bulk of their expenditures. In Riyadh's case, oil exports supply 70% of its revenues; in Moscow's case, the number is approximately 46%. Both countries have sovereign funds designed to cover shortfalls in government revenues from falling oil prices. Saudi Arabia's Sovereign Wealth Fund had $320 billion in assets, while Russia's National Wealth Fund had approximately $124 billion at the end of 2019.
The Trump administration was quick to characterize the Saudi and Russian decisions to increase oil production as a thinly veiled attack on American shale oil producers. The U.S. Energy Information Administration (EIA) estimates that 7.7 million BOPD, or about 2.81 billion barrels, of crude oil were produced from tight oil formations in the United States in 2019. This was equal to about 63% of total U.S. crude oil production last year.
This was not the first time that Saudi Arabia had tried to use low prices to force the producers of the more expensive shale oil out of the market. In response, President Donald Trump announced that the U.S. would buy up to 77 million barrels of oil from American producers for the Strategic Petroleum Reserve. Funding for these purchases was not, however, included in the recently passed 2020 Cares Act. In the meantime, the TRC announced that it would consider limiting Texas oil production to stabilize prices. Texas represents 40% of U.S. oil production.
Pundits were quick to take positions on which country, Saudi Arabia or Russia, would be able to hold out the longest in the ensuing price war. Meanwhile, television commentators pointed out that lower gasoline prices represented a boon for American consumers.
The more germane questions, however, are where does the U.S. interest lie? Is the U.S. better off from lower or higher petroleum prices? What are the consequences of lower oil prices on America's strategic interests around the world?
From the 1960s through 2013, the U.S. was the largest net importer of petroleum in the world. Lower petroleum prices were in America's interest as they decreased the balance of payments deficit created by oil imports and represented savings to American households. Today, gasoline costs represent around 2% of average household income. So even significant reductions in gasoline prices are not going to represent a major change in a family's income -- certainly not in respect to the current economic turmoil.
Moreover, given that the U.S. is now a net exporter of oil and natural gas, lower prices reduce its export earnings. Additionally, over the last two decades, the U.S. shale oil industry has emerged as an important driver of economic development and a source of high-paying blue-collar jobs. On balance, the U.S. economy would be better off if prices returned to their $50-to-$60 pre-crash levels than if they continue at their current depressed levels.
From Washington's standpoint, the strategic implications of low oil prices around the world are mixed. On the one hand, low oil prices are a significant constraint on the Russian government and on the Kremlin's ability to fund the expansion and modernization of Russian military forces. Russia needs oil prices at around $50 a barrel or higher to balance its budget, and closer to $75 to finance the more ambitious social and military programs that Russian President Vladimir Putin wants to implement.
On the other hand, low oil prices threaten to destabilize countries that are American allies and to create new areas of regional instability or aggravate existing ones. This is particularly true of the Gulf region, but also of countries such as Nigeria and Mexico. Roughly one-third of Mexico's federal budget comes from oil exports.
The average cost of producing a barrel of oil in the world is around $25. It's a difficult number to pin down because operating costs are typically in local currency and are affected by exchange rates, as well as each country's relative market share. Costs per country, however, can vary dramatically.
The U.K., whose North Sea oil fields are mature and declining, has a production cost of $52 per barrel. Norway, whose oil fields are in a similar position, has an operating cost of $36.10 per barrel. On average, the amortization of capital costs typically represents about 50% of operating costs. Direct production, overhead, taxes and transportation costs represent the other half.
The U.S., where oil shale production represents two-thirds of output, has an equally high cost at $36.20. Brazil and Canada, whose new oil production is particularly capital intensive, have costs of $48.80 per barrel and $41 per barrel, respectively. Russia's average production cost is around $19.20, although the cost of new production, especially in its Arctic oil fields, is much higher.
At the other extreme, Saudi Arabia has a production cost of $9.90 per barrel, while Kuwait has the lowest production cost at $8.50. Across OPEC, the average production cost is probably between $25 and $30 per barrel. That means, at current prices, most OPEC producers' costs exceed revenues after they factor in capital costs.
Only Iraq, Iran and the UAE have costs comparable to Kuwait or Saudi Arabia. In short, current oil prices are unsustainable long term. Even those countries that can produce oil profitably at these levels cannot produce enough to make up in volume the revenues they need to fund government expenditures. In the short term, prices may drop even lower but, in the long term, low prices are both unsustainable and extremely destabilizing politically.
The trends that produced the current instability in petroleum markets are not new. They have been in process for some time. The COVID-19 pandemic simply accelerated those trends and brought them to a culmination faster and more dramatically than would otherwise have been the case. Ironically, instead of dealing with the consequence of "peak oil" and skyrocketing prices, today we are dealing with too much production capacity and insufficient demand.
For much of its existence, OPEC has been an American nemesis, a position underscored in 1973 when the Arab members of OPEC (OAPEC) embargoed oil shipments to the U.S. in response to American aid to Israel. Historically, as a net consumer of oil, the U.S. wanted lower prices, while producers wanted higher prices. Today, however, it's a different world, one in which the interests of OPEC and the U.S. are more closely aligned.
Prices in the $50 to $60 range are sufficient to keep the U.S. shale oil industry economic and afford OPEC members a basis of financial stability. It's also in Russia's interest, as it stabilizes the Kremlin's finances, even if it falls short of Moscow's more ambitious goals. In the meantime, the U.S. petroleum industry will continue to innovate and to bring down its shale oil production costs, while continuing to expand its liquefied natural gas export capability. Moreover, the U.S. would likely get Canada, Brazil, the U.K. and Norway to participate, even if unofficially, in such an arrangement. The Alberta provincial government is already limiting oil production.
In light of the financial repercussions of the COVID-19 pandemic on the U.S. and the global economy, stabilizing the oil market and a key American industrial sector would be a first step in repairing the economic damage. It's time for Washington to make a deal with OPEC and Russia to stabilize the oil market, even if that means the U.S. must agree to some production cuts or export curtailment to ensure price stability.
