After OPEC

BIG companies making big bets on big oilfields, while a cartel of oil-producing states fixed the price to keep itself rich and others, including the oil majors, profitable. That, in caricature, was how the oil industry once ran.

That model now seems broken. On May 13th the International Energy Agency, representing the main oil-consuming countries, said a global oil glut was building, as Saudi Arabia pumped oil frantically in a continuing battle for market share with American shale-oil producers. The shale firms have proved a lot more resilient, and a lot more productive, than the Saudis and other members of OPEC, the producers’ cartel, had expected. Last November, with prices already slipping, OPEC’s members stopped trying to agree production quotas among themselves, sending crude tumbling further. Their hope was that this would force rival producers, especially in the American shale beds, to slash investment. As supply tightened drastically, the oil price would rebound.

This has not happened. Prices have staged only a partial recovery: West Texas Intermediate (WTI), one of the main benchmark prices for crude, was just above $100 a year ago and hit a low of around $44 in March; it had recovered to just $60 by the middle of this week. If the glut persists, the price is likely to slip back. As OPEC oil ministers prepare for a meeting in Vienna next month, a draft paper leaked to the Wall Street Journal said that even in its most optimistic scenario, the price will not exceed $76 a barrel until after 2025. It also considered a scenario in which it fell below $40. OPEC denied that the draft existed, but the conclusions ring true: the chances of a return to triple-digit crude prices look slim.

The big oil multinationals, such as BP, Chevron, ExxonMobil, Shell and Total, have responded to the weaker oil price by cost-cutting, and postponing and cancelling some of their exploration projects (although Shell this week got a provisional go-ahead to restart a $6 billion project in the Arctic, troubled by delays and accidents). However, the output of the shale firms has proved surprisingly robust, even though they have cut their number of rigs significantly since the peak last October (see chart).

One reason for this is canny hedging by some shale producers, which means they are in effect getting paid above the current market price. But many unhedged producers have also continued to pump oil, since the market price is still above the marginal cost of producing another barrel, even if it doesn’t cover the upfront costs of drilling the well. Most important of all, their productivity has continued to improve in leaps and bounds. Wells that used to take 35 days to complete now take 17, says Daniel Yergin of IHS, a research firm. The amount of oil produced per dollar invested will rise by 65% this year, he says. Better seismic data, improvements to the fracking liquids pumped into wells and more intensive deployment of rigs are all helping.

In all, IHS reckons that 80% of the new capacity this year will be profitable with WTI at $50-$69 a barrel. As its price has edged above $60 in recent days, some shale companies have begun to talk about increasing output again. The size of the “fracklog”, the pipeline of ready-to-roll projects awaiting better prices, is contested. But the principle is clear: American shale firms have become the new “swing producer” of the global oil market.

Its main influence used to be OPEC, and particularly the Saudis, switching the taps on and off to try to rig the price. Now the market is increasingly led by the American frackers, ramping their drilling up and down in response to global prices. Petromatrix, a consulting firm, has coined the phrase “shale band” for the price range between $45 and $65: below that range, American production falls sharply; above it, it surges. If so, there should be a tendency for prices to stay within that range.

The greater the proportion of the world’s oil supply that comes from fracking, the stronger this effect will be. The American government’s Energy Information Administration has in the past three years raised its forecast of American oil output in 2020 by 3.1m barrels per day to 10.6m—the equivalent of adding another producer the size of Iraq. There is scope to reduce production costs further through the consolidation of what is still a fragmented fracking business. This week, in the first big deal of its kind since the oil-price drop, Noble Energy said it would buy Rosetta Resources, a smaller and indebted rival, for $2 billion, paid in shares. More such deals are likely. Paul Stevens of Chatham House, a think-tank in London, expects a “flurry of mini-mergers”.

As American production continues to rise, pressure will grow on the government to ease its restrictions on exports of crude. In the meantime America’s imports are diving—they fell below those of China last month. Other countries, from Russia to Argentina, have promising shale beds. Although they lack America’s expertise, finance and legal system, they may eventually begin to produce oil from them in significant quantities.

All this leaves the Western oil majors in an uncomfortable place. They are used to overseeing huge, high-risk, long-term projects, and have not shaken the habit of indulging in costly bespoke solutions which delight their engineers but give their accountants nightmares. Mr Yergin of IHS notes that there are 328 standards within the industry just for valves. Contrast this with the shale firms, whose wells are small, cheap and drilled quickly using standardised, interchangeable parts. The current weakness in prices will eventually force the oil majors to strain themselves to find cheaper and more flexible ways of working, however. Oswald Clint of Sanford C. Bernstein, another research outfit, thinks that the majors have scope to cut perhaps tens of dollars a barrel from their breakeven prices.

Unless some large-scale conflict erupts that takes out some of the world’s biggest oilfields, the oil industry may be heading for a new normal in which the price of crude oscillates in the mid-double digits. The one thing that might make it break out of this range and head back above $100 is a surge in demand. However, economic growth and energy consumption have decoupled in the rich world; and it is an open question if emerging economies will be as wasteful of energy in coming decades as the established ones were in the past century. Ever more affordable renewable-energy sources, and cheap gas, are proving increasingly attractive alternatives to many users of oil products.

Paul Sankey of Wolfe Research, a New York-based outfit, believes that underinvestment resulting from the recent sharp dip in crude may lead to one last spike in the oil price; but after that, he reckons, the “oil age is over”. Even if that proves an exaggeration, a return of OPEC’s dominance seems a distant prospect.