Why More U.S. Oil May Not Mean Cheaper U.S. Gas

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Oil skeptics like to point out that the U.S. consumes 20 percent of the world’s oil but owns only 2 percent of global reserves. Such lopsided numbers, they insist, destine the U.S. to depend on foreign crude -- unless it slashes its consumption and embraces alternatives. Lately, though, a surge in U.S. oil production appears to have turned the tables.

In an interview with Bloomberg News early last year, Adam Sieminski, an analyst who would soon leave Deutsche Bank AG to join the White House staff, captured the mood: “For 40 years, only politicians and the occasional author in Popular Mechanics magazine talked about achieving energy independence. Now it doesn’t seem such an outlandish idea.”

Booming oil production will change the U.S. economy, international security and the global climate. But for many people, a simpler question matters most: What will U.S. oil abundance mean for the price of gasoline at the pump?

Because oil is traded globally, prices ultimately depend on how much is produced in the entire world, not just in the U.S. A world where the U.S. produces 10 million barrels of oil daily won’t necessarily have lower prices than one where it produces 5 million. After all, U.S. production was higher in 2010 than in 2009, but oil prices were higher then, too.

World Supply

That said, if the U.S. increases production while output from the rest of the world remains unchanged, total world supply will rise and prices will fall below what they otherwise would have been. How much so is tough to nail down, but if recent estimates from a team at the International Monetary Fund are right, a 5 million-barrel-a-day increase in oil supplies could cut prices in half.

So why isn’t everyone predicting plummeting prices? Because when U.S. oil production rises, other countries’ output usually falls, with the net result being a much smaller increase in world supplies, and hence less effect on prices.

Part of this is driven by markets: More U.S. oil means lower prices; lower prices render some oil projects economically unattractive; those either shut down or don’t reach production in the first place.

This is compounded by an even more important dynamic: Many countries try to maximize their revenue from oil sales by restraining production and propping up prices. Saudi Arabia, for example, can often profit more by producing less oil. And if several of these “strategic producers” cooperate, the payoff from holding back output rises. This is the goal of the Organization of Petroleum Exporting Countries. OPEC still produces 40 percent of the world’s oil, a figure that has moved up and down but hasn’t changed radically for decades.

All of this affects the potential consequences of higher U.S. oil production. As U.S. output rises, so that prices are inclined to fall, some oil-exporting countries will prop them up by cutting back their own supplies. If a 5 million-barrel-a-day increase in U.S. crude output is met with a 4 million-barrel-a-day cut in supplies from other countries, the net impact on prices is reduced by a factor of five.

There is a chance, however, that the dynamic could actually run the other way, leading to even-deeper price cuts: Big-enough gains in global oil production could spark a battle among OPEC members and other big producers for market share, leading to a crash in world prices.

To see how this could happen, imagine you are a strategist for a major member of OPEC, perhaps Saudi Arabia or the United Arab Emirates. Oil production outside the cartel is surging; production is on the rise not just in the U.S. but also in Brazil, Canada and beyond. You are worried about falling prices but don’t want to sell less oil. What you would like most is for others to curb their production. Everyone else, of course, feels the same way.

Cartel Calculations

Your next-best bet is to share the burden of restraint with your fellow cartel members (and perhaps a few others). As new production keeps rising, though, the burden grows heavier. At some point, discipline breaks down. You lose faith that others will curb their output and fear that if you keep dialing back your own production, other members might raise theirs and steal your customers. Even worse, with falling prices you have trouble meeting your country’s budget. So you turn to a final option: You crank up production in an attempt to sell more oil. The only problem is that several other countries have made similar decisions. Collectively, you flood the market. Prices plummet.

To be certain, there are limits to how far this dynamic can take things. Most new U.S. oil is relatively expensive to produce. If prices drop too far, U.S. production will stagnate or even fall, reversing the stimulus that had prompted lower prices. This makes it tough to see how rising U.S. crude production could drive world oil prices below $50 or so for more than a brief period.

Still, that price is far lower than what people have gotten used to.

So here’s the big question for anyone trying to divine the impact of rising U.S. oil production on world prices: Will other oil-producing countries, alone or collectively, restrain production to put a floor on prices? Or will discipline break down and result in a flood of oil?

Two episodes from history are illuminating. The first happened in the late 1960s and early ’70s. Oil production outside OPEC was rising, but consumption was increasing even faster. West Germany and Japan continued to grow as industrial powerhouses after World War II; the U.S. and the rest of Europe were increasingly thirsty for oil, too. As a result, OPEC had an ever-larger pie to divide: Its members could restrain production and still have high revenue. OPEC output didn’t grow a lot, but prices and incomes soared.

History Lessons

Fast-forward to the early 1980s. The Iranian Revolution of 1979 rapidly increased crude prices and crushed global oil demand. For the first time in decades, in fact, consumption fell year upon year. Supply from outside OPEC, meanwhile, continued to rise. OPEC’s pie was shrinking. Tough collective decisions were essential if prices were to stay high, but OPEC members weren’t up to the task. Instead, they battled one another for the ever-smaller market shares. Prices dropped to previously unthinkable lows, falling to barely more than $10 a barrel.

To figure out how OPEC countries will respond to rising U.S. supplies, then, it’s important to ask whether the increase will be taken up by even-greater demand. That’s where China, India and the rest of the developing world come in. The International Energy Agency has projected that demand for oil from the developing world will rise to 41 million barrels a day by 2020, from 32 million in 2008. Developed-world demand, meanwhile, is projected to fall by only a quarter as much. Other projections yield similar outcomes. The net result is a huge new market, particularly if little is done to curtail the world’s thirst for oil.

All this was at the front of my mind when I arrived at OPEC headquarters in Vienna on a cool spring day in 2012. OPEC’s influence has waxed and waned, but with almost half of world oil production within its member countries’ borders, and a far higher fraction of the world’s cheap crude, it still matters. Abdalla Salem el-Badri, a former Libyan oil minister, welcomed me. Trained at Florida Southern College, the onetime Esso Standard manager was by then 71 years old and serving his second term as secretary-general of OPEC.

I asked him how he felt about the boom in U.S. oil and gas production and was a bit taken back by his reply. “This is really good,” he said. Since Richard Nixon’s presidency, the U.S. has obsessed over its dependence on Middle Eastern oil, and now rising U.S. output could get OPEC off the hook. “They will blame us less,” he predicted. He pointed to the U.S. presidential campaign, which at the time was just warming up. “Fifty percent of it is about energy!” he said.

I pressed el-Badri on whether OPEC could weather growth in U.S. supplies. “Yes,” he said, “for us, it is important. But there is room for everybody.”

He’s probably right. In the short run, it’s entirely possible that the world will overinvest in oil production, leading to a temporary price crash. Over the long haul, however, there seem to be few limits to the world’s thirst for oil. And even though crude output is rising in the U.S. and Canada, it is declining in countries such as Norway and the U.K. Rapid production increases by producers such as Iraq and Venezuela could quickly alter the picture, as could a persistently weak Chinese economy, letting U.S. oil output tip the final balance. It would be unwise to bet on that, though. U.S. production may help keep a lid on prices, but will probably not do much beyond that in the long run.

Still it’s tough to be too confident. Oil markets are often as much about politics as economics, and predicting future political twists and turns should be done with care.

(Michael Levi is the David M. Rubenstein senior fellow for energy and the environment at the Council on Foreign Relations. This is the first of three excerpts adapted from his new book, “The Power Surge: Energy, Opportunity, and the Battle for America’s Future,” which will be published May 2 by Oxford University Press. The opinions expressed are his own. Read Part 2 and Part 3.)

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To contact the author of this story:
Michael A Levi at mlevi@cfr.org

To contact the editor responsible for this story:
Mary Duenwald at mduenwald@bloomberg.net