The massive drop in oil prices has been a spectacular to say the least. US oil prices have collapsed from a high of $107 in June 2014 to a low of $49 a barrel at the time of writing, which is the lowest price since April 2009.
Much of this decline can be traced back to the astonishing surge in US shale production (Figure 1), which has swamped the world with oil, much to the dismay of the OPEC oil cartel, which mainly consists of low cost Middle Eastern oil producers.
Figure 1: US oil production has tripled in the last two years (Source: Barclays)
Horrified by the prospects of losing their long-term power and influence within the oil market, OPEC has declared an all-out price war on US Shale oil producers by deciding not to cut production at their latest meeting in Vienna on November 28th 2014. In doing so, OPEC hopes to break the back of US shale producers.
Although low oil prices are damaging for all major oil producers, OPEC and in particular the Middle Eastern countries are of the belief that they are much better equipped to survive a low oil price environment.
Indeed, countries like Saudi Arabia and Kuwait have some of the lowest marginal cost oil production on earth, while their national coffers are filled with reserves from their Sovereign Wealth Funds. In contrast, many US Shale producers are highly indebted and require much higher oil prices to further increase their production.
At the moment it seems that OPEC’s strategy might be working, as the first cracks start to emerge in the defenses of US Shale producers. Firstly, an analysis conducted by Wood Mackenzie came to the conclusion that WTI prices under $70 do indeed hurt US shale companies and with oil prices currently trading under $50, almost all future US shale projects are uneconomical (Figure 2).
Figure 2: US shale feels the pain under $70 (Source: Deutsche Bank)
Secondly, US oil drilling has begun to fall sharply and we can expect this fall in production to continue throughout the first months of 2015, unless oil prices move up sharply (Figure 3). The fall in production has been particularly steep in the four shale oil regions of Bakken, Eagle Ford, Niobrara and the Permian.
Figure 3: US drilling activity is plunging (Source: Standard Chartered)
Although OPEC’s merciless strategy will cause massive collateral damage by driving allied countries such as Venezuela, Russia and Nigeria to the edge of bankruptcy. It is a price they are more than happy to pay, in order to crush their US competitors.
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Simon is the CEO and Editor-in-Chief of Foresight Investor. He has been following the markets passionately for over 7 years.