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The Unstoppable Shale Revolution

Pramit Pal Chaudhuri, Hindustan Times

The oil market is in a state of insurrection. The production-owning elite has paralysed itself while legions of bolshie shale operators who are undermining the system from down below. The revolution is now — and it’s black and greasy.

When it comes to price predictions, few things have become as slippery as crude oil. The big economic shock of this year is likely to transmute into several big political stories in 2015 as the consequences of the collapse in oil prices unfold.

Shale oil and gas are revolutionary. But their real impact will be to destabilise the once well-buffered global oil price system. The present low stickers on crude barrels may not last, but for importers like India the instability will.

Here are three reasons why oil prices will be a roller coaster next year.

First, oil has lost its central bank. Saudi Arabia has long served as the ‘central bank of oil’. It has used its enormous surplus production capacity to keep the petroleum market stable. It used to pursue a Goldilocks formula knowing that oil too dear collapses demand, while oil too cheap undermines the investments that keep black gold flowing.

But Riyadh’s central bank’s role is being trumped by the geopolitical uncertainty being generated by the United States shale revolution. Saudi Arabia has long sought to hold onto a minimum of 10% of the US oil market — what it believed was needed to keep Washington geopolitically interested in the Persian Gulf. That is now under threat as is the US need for Persian Gulf crude at all. The Saudis have been buying up US oil refineries, forcing them to buy Gulf oil and thus artificially upholding US imports from their region.

When oil prices tumbled, Saudi Arabia asked itself what would happen if it didn’t cut production. The answer: It would blunt shale production in the US, break the bank of archenemy Iran, and drive out high-price oil producers arresting a supply glut. As the Saudi oil minister, Ali Al-Naimi, asked earlier this month, “Why should I cut production?”

That oil prices fell was not a surprise. Many energy analysts had been predicting this simply because supply was outstripping demand. The surprise was the Saudi’s decision to do nothing about it.

Second, the shale insurgency will survive. Oil prices can never fall low enough and long enough to put the US shale industry out of business. Shale formations differ too widely to be all affected by a single price signal. Some rigs produce oil at 99 cents a barrel, some at $70; some last six months, some last five years. Analysis by ITG Investment Research shows 88% of US shale oil output is profitable even if global oil prices fall to $25.

It is not that keeping low prices won’t have an impact. Already, new shale oil drills have fallen dramatically. As shale wells tend to tap out quickly, a half-year of low prices would hurt. But technology keeps driving down the price of shale extraction and the industry has an efficient futures market that has kept funds flowing. The possibility of the US central bank raising interest rates in the coming months — and throttling the cheap capital that greases the shale industry — may do more damage to shale oil production than Saudi machinations.

The real revolutionary aspect of shale oil is that production can be turned on and off with unprecedented speed. Traditionally, oil prices can take as much as a year to respond to market developments. With shale, this will be reduced to just a few weeks.

This, in turn, means oil prices will have a tendency to gyrate even more than usual. The shale spigot can be turned on or off in response to price signals of only one or two months. Thus oil prices may rise to $80 next summer as global supply tanks. If so, it will fall within months as shale oil starts to gush again.

Third, political fallout has just begun. Petrodollars sustain a lot of regimes, mostly nasty, around the world. Some of these are now looking down a very black hole. Regime change is most likely in Venezuela, a government that amazingly ran up a fiscal deficit of 16% of GDP even when oil prices were $110. Look out for a Caracas meltdown next year.

Iran, Russia, Algeria, Angola and Nigeria are countries that will suffer if oil prices stay below $100 a barrel. Expect social unrest in these countries all through next year, some may become more belligerent overseas to compensate.

Those affected include terrorist groups. The Islamic State (ISIS) will get less revenue from the oilfields it captured in north Iraq. Boko Haram may benefit as the Nigerian army struggles for funds. So add a lot of political risk to the oil mix.

Riyadh won’t suffer. Saudi Arabia needs billions for its welfare programmes, but it also has $740 billion in reserve assets that will last it years. In theory, China should lose interest in the South China Sea as offshore oil and gas become largely unviable. But don’t count on it.

The supply and demand in oil will roller coaster a lot this year. No one knows what the bottom is. Suhail al-Mazrouei, United Arab Emirates’ energy minister, declared a few days ago: “We are not going to change our minds because the prices went to $60, or to $40.”

India can bask in the overall lower prices, but could do more to buffer itself against instability. One cue is to look to China that is reportedly topping off its emergency crude reserve with an additional 200 million barrels. Another is to consider a long-standing Singapore proposal to set up a financial energy hub, complete with an oil and gas futures market, in the region. This would help hedge against price risk. One downer is that it may have to give up the idea of indigenous oil and gas production. Low prices plus Indian red tape should kill off the miserable NELP once and for all.

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