America: Oil's New Swing Producer

August 12, 2015 Topic: Economics Region: Americas Tags: United StatesOilSaudi Arabia

America: Oil's New Swing Producer

"In time, this new reality just might make the Middle East less imperative for the U.S. policy than it has been for the last half century."

A new system now dominates global oil markets. Part of it rests on enhanced North American production capabilities. Just as important is how cash needs among other suppliers, including Russia and Saudi Arabia, force them to sell just about all the oil they have just about all the time, almost regardless of price. This combination of circumstances has thrust North American operations into the position of what the industry calls the “swing producer,” effectively the source that varies to balance global supply with demand. The structure is still relatively new, but it promises the world fewer violent price moves than during the past half century. There are, however, circumstances in which it will break down.

This turn does bring a delicious irony. The United States held the swing position for decades before the 1970s, when the Organization of Petroleum Exporting Countries (OPEC), Saudi Arabia in particular, took it away and, for almost fifty years, used it to manipulate global oil supplies and set prices for its own political purposes. Now world oil markets have come full circle. To be sure, America’s recaptured dominance has a different look from the last time it held the role. Back then, the Texas Railroad Commission used a mechanism called proration to stabilize world prices by swinging Texas output up or down to compensate for the production moves of others. Today, there is no such governing body, but the present structure accomplishes much the same thing.

It certainly will tend to stabilize prices if the Iran nuclear deal goes through, and an abundance of Iranian oil flows onto world markets. During the last half century, such an addition to global supplies would have produced a radical price drop unless Saudi Arabia, for its own purposes, cut its output. Indeed, recent price declines likely reflect expectations of just this effect. But with profit-sensitive American producers now in the swing role, there is a greater assurance of offsetting cuts. The tendency for additional Iranian supplies to put downward pressure on prices will render some North American wells less lucrative, inducing production cutbacks that will mitigate the global supply impact of new Iranian flows and so also blunt the extent of any price movement. The balancing effect should occur even as the absence of sanctions enables Iran to import technologies that will enhance its exploration and pumping capabilities.

Swing production in North America would work the other way if the nuclear deal were to fail. Because then the much-advertised “snap back” would reestablish sanctions and keep Iranian supplies off global markets, prices would experience upward pressure from today’s levels. The accompanying improvement in the profitability of marginal North American operations would prompt a production increase in the United States and Canada, substituting for the lack of an Iranian flow and stabilizing prices, at least relative to what otherwise would have occurred.

Even with a continued abundance of Iranian supplies, North American production will eventually have to increase. Depletion will reduce flows from Venezuela, Russia and other producers, effectively making room for U.S. and Canadian output. At the same time, relatively stable, low prices will tend to increase demands for oil by making it harder for alternatives to compete, by prompting more-lavish uses of petroleum (read a preference for SUVs) and by spurring economic growth. As these shifts take hold, global prices will again rise. But by drawing out North American production, they will remain contained. Presumably, that price moderation will allow users to continue to indulge in the new, more-lavish uses for petroleum products.

If this new system promises relative price calm in most circumstances, it cannot do so in all circumstances. Stability, after all, rests on the willingness of other suppliers to sell all they have on an ongoing basis. Though each has political and economic reasons to do so, any number of imperatives could prompt them to change their policy. The Middle East’s chronic instability is the most likely source of such a change. It has certainly caused major supply interruptions in the past. Beyond a point, such interruptions could overwhelm the ability of North American production to offset and so also overwhelm its ability to keep prices in line.

Consider, for instance, the prospect that failure on the nuclear deal or one of any number of other potentials raises tensions to the point where Tehran threatens to close the Persian Gulf to shipping. It has done so more than once in the past. Such an act would block not only Iranian shipments, but also most supplies from Iraq, Kuwait, Qatar, Bahrain, Oman, Saudi Arabia and the oil Emirates, in other words some 30-35 percent of the world’s oil shipment. North America, even with all the technology in the world, lacks the ability to replace the loss of this much oil, especially over a short time frame. Nor could the Navy’s assurances that it could keep the Gulf open offer much help, for any shooting in the Gulf, or even just the threat of it, would prompt insurers to either refuse to cover the ships and their cargos, or charge such high premiums it would amount to a refusal. Then, just as when the oil embargoes of the early 1970s overwhelmed the ability of the Texas Railroad Commission to increase supplies sufficiently, prices would spike up, probably to well over $100 a barrel.

Still, this new system, if not failsafe, is a vast improvement on the past. Because it (in most circumstances) enables the world to look forward to the relative price and supply stability, it promises a more-reliable flow of critical resources and gives government, as well as business, a greater ability to plan, all of which should improve economic prospects for the United States and the world. In time, this new reality just might make the Middle East less imperative for the U.S. policy than it has been for the last half century. But just as with the Texas Railroad Commission and the earlier system of stability, a vulnerability to extremes remains.

Milton Ezrati, a contributing editor to the National Interest, is senior economist and market strategist for Lord, Abbett & Co. and an affiliate of the Center for the Study of Human Capital at the University of Buffalo (SUNY). His most recent book, Thirty Tomorrows, on the challenges of aging demographics and how the economy can cope, was recently released by Thomas Dunne Books of Saint Martin’s Press.

Image: Wikimedia/Eric Kounce TexasRaiser