A game of 'chicken' threatens the oil production balance

'Mexico is poised to redraft part of next year's federal budget after a steep fall in oil prices upended the country's revenue assumptions.' - Financial Times, October 28

There will be blood, eh?

Below $80 per barrel you can bet on it. As the research team at Goldman Sachs noted this week, low US oil prices are leading to a monumental shake-up in the oil-producing world, which might bust the Opec cartel of oil-exporting nations.

What happened to all the talk of 'peak oil'?

Well, as they say, "there's no better cure for high prices than high prices". In 2008, when oil prices reached $145 a barrel, the economy had been growing for years. Producers could not deal with all that demand.

So prices went up?

Right. A major price recalibration was needed to encourage investment, the sort that didn't seem worthwhile or looked too risky when prices were low. The idea behind "peak oil" was not that we would run out of extractable oil. It was that we might lack the incentive to invest in more expensive extraction until it was too late. The irony is we have ended up with the shale oil and gas boom instead.

Why is that ironic?

Well, seven years ago it wasn't clear whether hydraulic fracturing would ever be a dependable source of oil. The technology looked erratic. And no one appreciated how much investment would go into so-called tight oil once it became cost-effective.

So how much has US oil production increased?

According to a study released this month by Wood Mackenzie, US oil and gas output has risen an astounding 42 per cent in the past seven years, putting the US on track to be energy-independent by 2025. At this point the US could end up exporting more than it imports.

If the US is producing more, who is producing less?

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But if demand in the future falls, won't someone eventually have to slow production?

Absolutely. Otherwise a collapse in prices will put every producer off and risk leaving everyone without fuel. The problem is, whoever cuts first loses the revenue to someone else. It is a game of "chicken".

So who's in the strongest position?

Whoever has the lowest costs or the biggest financial reserves, which - if pressed into production - can compensate for the lower price per barrel. For example, Saudi Arabia needs a price of between $83-$85 a barrel to balance the government's books. However, if you take the kingdom's reserves into account, it could take seven or eight years before Saudi Arabia faced any real financial distress. Nigeria's position is quite different. It is said to need a price of $158 a barrel, meaning the country is probably already in pain. Things don't improve much even if you account for the African country's reserve position. If prices stay at $83 a barrel, it could run through its buffer of reserves in less than four months.

Surely there's a break-even rate for US shale producers too?

Yes there is. According to Wood Mackenzie, US shale oil developments would remain economic even if prices were as low as $70 or $75 a barrel. Some even say that most American producers would wash their face even if a barrel fetched only $57. But the difference is that in the US, none of the producers are state-owned. Also, America doesn't depend on oil export revenues to balance the government's books. True, lower prices might no longer be a cause of unalloyed economic cheer. Because they thin the wallets of oil producers, they make life harder for the people whose livelihoods depend on them. Still, cheaper oil could also help stimulate the economy by reducing the price motorists pay at the pump, and bringing down the cost of industrial inputs. That would help put more people in work, and give them more money to spend after they leave the petrol station forecourt.

But that doesn't change the fact that someone will have to cut eventually?

You're quite right. Goldman Sachs predicts that by 2015 the global oil market could be significantly oversupplied. The question is, who will make the first move? Whoever does, of course, will become the new producer of last resort - the one the world expects to swing first when the oil price pendulum turns.

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