The Fuse

Why the U.S. is Not the New “Swing Producer”

by Nick Cunningham | May 27, 2015

The surge in U.S. oil production, now above 9 million barrels per day, has induced a supply glut. OPEC, meanwhile, responded not by cutting production, but by pumping more oil, in an effort to maintain its market share. Is that evidence of shale triumphing over the cartel? Did OPEC and Saudi Arabia forfeit its role as swing producer?

The Economist thinks so. In a May 16th article entitled “After OPEC,” the publication declared that shale oil companies are now the world’s swing producers. U.S. producers would now add new oil when prices rose past a certain point—arguably $60 to $70 per barrel—and would cut back when prices dropped. In the Economists’ argument, that bestows geopolitical benefits upon the U.S. in the form of oil price stability and enhanced influence.

But is the U.S. really a swing producer, and would it even wish to play such a role? Not exactly. Here’s why:

U.S. drillers can’t coordinate. The U.S. is nothing like Saudi Arabia. U.S. oil production is made up of hundreds of private companies, all who are out for profit and are accountable to their shareholders. What makes sense for a state-owned oil company in Saudia Arabia—driven by political and social objectives—doesn’t for a driller in Texas. That means there is no possibility of a coordinated response at a certain point in time. Want to pair back production to boost prices a bit? Good luck getting all the drillers on the same page.

Even if they could coordinate, most wouldn’t want to. Not only are drillers not looking to influence the price of oil, but few would even want to ratchet down or up their production levels. Pulling back on output would mean a corresponding drop in cash flow, undermining their bottom line. And, with the possible exception of Saudi Aramco, no single company can have an effect on prices, so reducing output would result in an immediate loss for the company. Moreover, many of these companies have debt payments to service, and pumping full tilt is either contractually required or is the only approach that makes sense, given their fiduciary responsibilities. Ultimately, that means no driller is going to cut back unless they start losing money.

Even if they wanted to, U.S. shale companies couldn’t respond quickly. Market watchers are expecting U.S. shale producers to cut back and sit on the sidelines until prices recover. That has led to heightened interest in data points like rig counts, weekly production data, and inventory levels. But six months after OPEC decided to sweat U.S. shale by leaving production unchanged, U.S. oil output hasn’t significantly dropped, at least not yet. It probably will, but as we’ve already noticed, ramping down shale involves a huge lag period, and drillers are also becoming more efficient while squeezed by low prices. That is because, again, many companies are pumping for dear life, hoping to live another day. As a result, the U.S. oil patch does not respond quickly to changes in price levels.

Being the marginal producer is not a good thing. It’s true that in the aggregate, U.S. shale production will go up and down in response to swings in price. And certainly, shale can be ramped up or down quicker than conventional drilling, especially compared to offshore operations. But is that really a good thing for these producers? That simply means shale is high-cost, and being a marginal oil producer makes you less competitive than your peers in a low price environment. With a lot of companies operating in the red, the U.S. oil industry is not exactly operating from a position of strength.

No “spare capacity” in U.S. Saudi Arabia has been able to hold the title of “swing producer” because it has historically held several million barrels per day of oil capacity sitting in its back pocket. The same is not true for U.S. companies. Sure, if prices rise, more wells will be drilled and more oil will be produced in marginal areas. But that’s not “spare capacity.” That is simply a regular response to price changes. Saudi Arabia, on the other hand, can turn on several hundred thousand barrels or more per day within a matter of weeks and regardless of price. U.S. drillers operate on a timeline of months to adjust production, and will produce as much as they can given a certain price level—but they aren’t sitting on latent output.

 

Bottom line for this market landscape: Shale companies are just like every company. Their only objective is profit, and they lack any special ability to influence prices in the short-term. And unlike certain Middle-Eastern regimes, the U.S. government can’t force drillers to take a given action in order to advance some geopolitical objective. Yes, producing oil from shale is quicker than from conventional sources, but Saudi Arabia is still the world’s only “swing producer.”