Oil Price War: Is U.S. Shale The First To Blink?

Hunter Kornfeind, intern for Energy and Climate Policy at the Council on Foreign Relations, contributed to this blog post.

As the oil price war continues, markets are hanging on every word coming from Washington, Moscow and Riyadh, amid signs that diplomacy could be afoot. A statement by the Kremlin’s presidential spokesperson, that Russia would like to see higher prices, signaled that Russia might be willing to blink in the Russia-Saudi oil price standoff. It appears that the fall in the ruble is larger than Moscow expected, prompting them to use up foreign currency reserves at a faster clip than anticipated. Russia could also be finding it more difficult to sell its oil in China and Europe.

Earlier in March, Russia joined deliberations at the gathering of the Organization of Petroleum Exporting Countries (OPEC) and refused to agree to any further production cuts to support prices. Russia’s refusal to negotiate was in part because, by restricting output, Russia believed it would be propping up U.S. oil exports to Europe and elsewhere, potentially at its own expense. Russia also privately expressed the sentiment that the cuts being contemplated by the OPEC Plus group, at the March meeting, would fall short in countering the massive losses in oil demand due to COVID-19 related shutdowns.

Saudi Arabia, which had been trying for weeks to broker an agreement for deeper collective cuts in production, ramped up its own oil production to near its maximum levels in response to Russia’s refusal to contribute a new round of oil output cuts. Amid assessments that the world could soon run out of places to store oil surpluses, oil prices began to plummet. Cornerstone Macro is estimating that current trajectories, if not adjusted, could result in a buildup of surplus oil in inventory totaling 600 million barrels by year end.

Now, with all eyes on the standoff between Russia and Saudi Arabia, the question of what would bring both parties back to the negotiating table is a tricky one. U.S. diplomacy could focus first on Riyadh, since Moscow might already be wavering. But with mounting pressuring on U.S. oil producers to throttle back, it’s not too early to wonder if Russia and Saudi Arabia have already accomplished their aim and the first to blink has actually been U.S. shale.

Wither Fracking

There are several factors beyond current geopolitics that are creating headwinds for U.S. shale producers, who in recent years have been able to increase U.S. oil and gas production dramatically using innovative improvements to the oil drilling technique of hydraulic fracturing (or “fracking” as it is commonly referred to). Continued low oil prices constrain companies’ capital budgets, a prospect already prompting some companies to make reductions in drilling activity. Investor enthusiasm for the sector was already waning due to a risky long term investment climate for oil and gas, adding to some companies’ looming financing woes. In addition to the market instability facing U.S. frackers, Democratic presidential hopefuls are also drawing a target on the sector’s back, calling for greater restrictions on operations.

In recent days, several major U.S. independent producers including Pioneer Natural Resources, Occidental Petroleum, Concho Resources, EOG Resources, and Diamondback Energy have announced that they intend to cut drilling plans in an effort to preserve capital amidst falling oil prices. ExxonMobil also reversed plans to increase spending on exploration and production, expressing this week that it would make significant reductions to capital expenditures this year, including reducing its shale drilling activities in the prolific Permian Basin in Texas. The onshore shale industry represents roughly 60 percent of total U.S. crude oil production, roughly 8 million b/d out of a total of 13 million b/d. U.S. crude oil exports hit new records just prior to the coronavirus outbreak to reach 3.6 million b/d. Added together with refined product exports, a total of 9 million b/d of U.S. petroleum was leaving U.S. shores.

Consultants Rystad Energy say it would take several months for cutbacks in drilling going forward to translate into lower U.S. shale production taking into account new wells already planned or in operation. The consulting firm suggests even at prices below $30 a barrel, onshore U.S. production could still grow by 200,000 b/d to 300,000 b/d in the next few months, before starting to decline in the fourth quarter of this year. Analysts at Citi suggest that some companies are slowing the work of fracking crews, leaving a larger number of drilled but uncompleted wells (DUCs) that could be produced later on, if oil prices rebound. Citi expects U.S. production to start to fall in the third quarter and potentially decrease substantially in 2021, depending on oil price levels. The prospects that U.S. oil production could sink later this year begs the question of what would Saudi Arabia and/or Russia consider a success against U.S. shale and thereby choose to reconsider their approach to markets.

U.S. Secretary of Treasury Steve Mnuchin has emphasized the importance of more “orderly energy markets,” a stance in line with President Trump’s announcement that the United States will add U.S. crude oil to the Strategic Petroleum Reserve (SPR). The administration has to concern itself with failures in U.S. banking and credit markets that could be triggered by sustained low oil prices. By injecting U.S. production into the SPR, the United States would be taking oil off the market to sell at a later date, in effect, mimicking a short-run production cut. This stop gap measure by the Trump administration, to provide some support to the energy sector amidst coronavirus, strengthens the signal to oil producers that the U.S. is going to want to see a restoration of some level of stability to oil markets. The SPR move undermines Russia narratives that the U.S. has been using sanctions to make space for U.S. oil and gas exports at Russia and Iran’s expense. That thesis has been put forward by Igor Sechin, one of Putin’s top energy advisors and the CEO of Russia’s flagship oil firm, Rosneft, whose trading arm is under U.S. sanctions for trading oil with Venezuela. How the United States handles sanctions against Rosneft could be a variable in any diplomacy related to the oil price war.

But the geopolitical backdrop to oil is not the only thing U.S. frackers have to worry about. Fracking took center stage in the March 15, 2020 Democratic debate where Democratic Presidential candidate Bernie Sanders laid out a proposal to ban fracking and U.S. oil exports altogether. Senator Sanders stated that, “it is insane that we continue to have fracking in America. It is absurd that we give tens of billions of dollars a year in tax breaks and subsidies to the fossil fuel industry. This has got to end and end now if we love our kids and future generations.” Democratic front-runner, former Vice President Joe Biden initially said he also supported a fracking ban but later clarified that he was referring to oil and gas drilling on federal lands because a full-on national ban would be politically impossible to implement. Estimates vary on how much oil production would be lost if fracking was banned on federal lands. One issue with the former Vice President’s proposition is that companies might simply shift activity to private lands once federal leases were no longer available. Oil companies also tend to apply for drilling permits on federal lease holdings up to 18 months to two years in advance, meaning that a backlog of existing leases on federal lands in New Mexico, Wyoming, and North Dakota, might get worked off before a fracking ban hit U.S. output on federal lands substantially. Still, consultants Wood Mackenzie Consultants say implementation of a ban onshore fracking of shale wells on all federal lands could reduce U.S. oil output by 750,000 b/d by 2021. RBC Capital Markets estimates a smaller impact of roughly 330,000 b/d if the first year of the ban was 2021. U.S. natural gas production could also fall, potentially by 2 billion cubic feet per day (bcf/d), according to estimates from other financial analysts.  

The scale of a fracking ban on federal lands would not on its own kill U.S. exports, which are more than five times the volume that analysts believe could be lost. OPEC Plus, however, would likely benefit either in the form of higher prices or higher sales, according to industry analyst Michael Lynch. But that eventuality, if it were to come to pass, does not seem to be factoring into OPEC or Russia’s current calculation. That means production shut-ins from some other kind of upheaval will likely happen first.