Blog Post

Where Falling Oil Prices May Take Us Next

Dec 3, 2014 | Alan J. Krupnick

The world economy has seen a 40 percent drop in oil prices since mid-June, partly because of a recent Saudi Arabia decision to not cut oil production in the face of global oversupply.  This price drop, should it last more than a few months, raises the issue: Will low prices end or seriously diminish the revolution in oil production in the U.S. created by hydraulic fracturing and other related technologies?

In the short term, data from the U.S. Energy Information Administration (EIA) show that the U.S. industry is weathering the price drop well so far.   The EIA’S weekly oil production report shows that U.S. crude oil output actually increased from last week over the weeks before to its highest level ever: over 9 million barrels per day.  Comparing financial statistics EIA gathered on 30 publicly traded companies operating in tight oil areas for the 3rd quarter of 2013 to those of the third quarter 2014 shows that net income is way up, debt increases are much smaller and return on equity rose from about 7 percent to about 23 percent.  They are also protecting themselves from falling oil prices by hedging.  Nevertheless, what are termed asset impairments rose, which means that companies are writing down the value of the reserves because of lower oil prices.

While these statistics present a fairly rosy picture, not included in the EIA survey are the smaller, privately held companies, whose finances may be less able to withstand low oil prices for very long.  The result may be industry consolidation, a good thing for the environment if you believe that the larger, publicly traded companies are better stewards.

If prices hover in the $60-70 per barrel range for some time more, will the pain eventually be felt in the oil patch?  The relationship between the marginal costs of extracting a barrel of oil and the oil price is key.  There is large variation in well productivity. Even in the most favorable locations.  Thus, the industry says that some wells in the Bakken shale formation in North Dakota, for instance, start to become uneconomic at $70 per barrel, with significant numbers uneconomic at $60.  The  current price is $71, up from $66 a few days ago.

One thing is clear: exploiting tight oil deposits requires a lot of churning, tight oil wells decline in productivity much faster than conventional wells, which means there is a continuous need for financing, drilling rigs, and gathering lines, not to mention railroad cars to transport Bakken oil.  If prices don’t rise soon, this churning will stop.  The major companies, in particular, will be quick to exit when expected rates of return fall below those of other investments.  While localized and even state level economic disruptions will follow, some slow down might have a silver lining for the environment (beyond the slowdown itself), if it allows time for improvements in regulations in places like North Dakota.

But in the longer term, higher oil prices are likely, primarily because of increased population and oil demand in growing developing countries and the limited ability of major supplying countries like Russia and Saudi Arabia to withstand the cut in their revenues.  To help supply this growing demand, as we have said in previous blogs, it makes economic sense for the U.S. crude oil export ban to be lifted.