The ‘fracking revolution’ has transformed the economics of oil production globally, with the US becoming a bigger producer than Saudi Arabia and – after decades of dependency on oil imports – even being able to export some of its surplus production.
US shale oil is unusual, too, in being privately owned: most of the world’s oil reserves (over 70 percent) are in state hands. Like the North Sea 30 years ago, in a world dominated by state-owned companies and publicly owned reserves, US shale could look like a new frontier for private operators on the search for fat profits.
New technology, high oil prices, and plentiful cheap credit have encouraged the boom. Some $200bn has been borrowed to invest in fracking in the last few years, accounting for 15 percent of the entire $1.3tr US junk bond market. Investors were, in effect, betting on continuing high oil prices making their investments profitable for years to come.
Last year’s slump in prices trashed that calculation. From a mid-year high of $115 per barrel, by the end of 2014 the price per barrel had fallen by more than 40 percent. More than half of US shale rigs have been laid up since October.
The driver, last year, was the behaviour of OPEC – the Organization of Petroleum Exporting Countries. OPEC is a cartel agreement among major oil producers that seeks to manage the international market for oil. With oil prices already plunging over the summer, OPEC could be expected to ease off on production. Restricting supplies should, thanks to the magic of the market, produce a decent increase in the sale price of oil. Instead, with Saudi Arabia taking the lead, OPEC decided to continue production levels. No agreement on restricting output could be reached. Prices slumped.
The economics of oil production are simple – crude, even. The upfront investment needed to sink a new well is significant. After that point, however, the variable costs – including pay – are a minimal part of the expenditure. That’s the case even when, as in Norway, oil workers’ average annual wages are $179,000.
These high initial costs, relative to lower running costs, mean that once a well is drilled the owner has a huge incentive to keep on drilling – even at very low prices. If they can cover their immediate costs, which are low relative to the initial outlay, they can make a profit in the short run.
But that creates a ratchet effect: once a well is drilled, only a spectacular fall in the price of oil will stop oil from being pumped. The more oil is pumped, however, the lower the price is likely to fall. Each producer, in this scenario, is trapped into producing more and more, driving down the price further and further. This effect has meant the slowdown in US shale output has been far slower than might have been expected, given the dramatic decline in price.
Read more: Desmog