May 2016

Adjustment in the Oil Market:

Structural, Cyclical or Both?

OXFORD ENERGY COMMENT

Bassam Fattouh

1. Introduction1
Between 2011 and mid 2014, the Brent price oscillated within a very narrow range of $100 to $110
per barrel. This relative stability was remarkable given the various shocks that struck the oil market,
these included macroeconomic shocks in the aftermath of the 2008 global financial crisis; geopolitical
shocks and unplanned outages as a result of political turmoil in many parts of the Middle East and
Africa (and the international sanctions regime targeting Iranian crude oil exports); and North
Americas unconventional oil supply shock. This relative price stability, however, was disrupted in
June 2014 when the oil price began to fall sharply, and indeed the drop in global crude oil prices in
the second half of 2014 has been dramatic. The cumulative oil price decline between June 2014 and
January 2015, as noted by the World Bank, is the third largest seen in the past 30 years, surpassed
only by the price collapses in 2008 and in 1986.2
This sharp fall in the oil price has divided the views of analysts regarding the nature of the latest oil
price cycle. Some argue that the oil market has been subjected to structural shocks that have created
a new global oil order3 and that we have entered a world of oil prices being lower for much longer.
Others are of the view that oil prices will rise sooner than currently expected and the current price fall
has many of the characteristics of previous cycles. These two views reflect the high degree of
uncertainty engulfing the oil market. This raises some key questions: Has there been a structural shift
in oil market adjustment mechanisms? Is the cycle different this time? And if different, how?
Every oil price cycle has its own special features and this cycle is no different: the advent of US
shale and the associated shifts in crude oil and product trade flows, the entry of a new set of players
with a new business model, lack of OPEC cohesion, the rebalancing of the Chinese economy, and
the changing nature of the geopolitical risks, just to mention a few. However, some fundamental
features have run across all previous cycles: the problem of excess supplies (ex ante) caused by
supplydemand imbalances and the rising levels of inventories.4 Since 2014, global supplies have
been exceeding global consumption and the world has been adding stocks every quarter, with key
international energy agencies such as the IEA and the EIA expecting this to continue for the rest of
2016 (Figure 1). Crude stocks are currently well above the five-year average and, unlike the position
at the start of 2015, products stocks are also above the five-year average, mainly due to the increase
in diesel stocks and, most recently, gasoline stocks (Figure 2).

The author would like to thank Adeeb Al-Aama, Majid Al-Moneef, Giacomo Luciani, and Adnan Shihab-Eldin for their valuable
comments on previous drafts and also the Kuwait Foundation for the Advancement of Sciences for funding support.
2
See Baffes, J. M., A. Kose, F. Ohnsorge, and M. Stocker (2015), The Great Plunge in Oil Prices: Causes, Consequences,
and Policy Responses, World Bank Group, Policy Research Note, 15/01.
3
Goldman Sachs, The New Oil Order: Making Sense of an Industrys Transformation; www.goldmansachs.com/ourthinking/outlook/the-new-oil-order/#overview.
4
Mabro, R. (1998). The Oil Price Crisis of 1998, Working Paper SP10, Oxford Institute for Energy Studies.

2
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

Figure 1: IEA Estimates of Implied Stock

Fig 2: OECD Stocks relative to 5yr-avg, mb (201016)

250

Crude

200

Products

150
100
50
0
(50)
(100)
(150)
10
Source: IEA.

11

12

13

14

15

16

Source: IEA.

2. Adjustment on the Supply Side

In the face of a supplydemand imbalance, there are two fundamental ways for the market to adjust
and for inventories to fall. The market can rebalance through adjustments in demand and supply in
response to price signals. Alternatively, producers can cooperate and cut production to clear excess
supplies. Both these adjustment mechanisms have their own lags and are associated with a high
degree of uncertainty; history has shown that adjustment in the oil market is far from smooth and can
result in some sharp price movements.

2.1 Non-OPEC supply outside US Shale

A key characteristic of non-OPEC supply (outside US shale) is the capital intensive nature of oil
projects and the relatively long-term investment cycle. High capital intensity implies that while the cost
of bringing an oil field into production is high, the variable cost of producing oil is relatively low. Once
fixed costs have been incurred, producers will continue to produce from existing fields even in a lowprice environment. In other words, in the short term, oil supply is highly unresponsive to price
movements. This is compounded by the fact that in a falling market it is likely that the variable cost will
fall, as oil companies can exert pressure on oil service companies to reduce costs. This explains in
large part why, despite the sharp fall in the oil price in 2014 and 2015, output continued to grow in
almost every part of the world in 2015, with non-OPEC supply (outside the USA) adding more than
600,000 barrels per day (b/d) (Figure 3). In 2015, the USA remained the main source of non-OPEC
supply growth (around 800,000 b/d), but the sources of this supply growth have become more varied
(US shale, Canadian oil sands, Brazilian deep offshore, Russian and Chinese conventional) with
different investment cycles and production profiles (Figure 4).

3
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

Figure 3: Non-OPEC Supply, y/y, mb/d (201216)

Source: Energy Aspects.

Figure 4: Key Areas of Growth in non-OPEC in 2015,

y/y kb/d

Source: Energy Aspects.

Another important characteristic of non-OPEC supply outside US shale is the length of the investment
cycle. The time lag between the point at which a Final Investment Decision (FID) is made and the
start of production is measured in years not months. Once costs have been sunk, producers are
unlikely to reverse the investment decision on a project. Thus, despite the fall in the oil price in recent
months, new projects continued to come online in 2015 and 2016 and are expected to continue doing
so in 2017. It is estimated that more than 2 million barrels per day (mb/d) of new projects will come
online in 2016 (Table 1). The pipeline of new projects will start slowing down in 2017 but only
marginally; it is estimated that around 1.7 mb/d of new projects will come online in 2017 (Table 2). All
these projects were sanctioned during the period of $100 plus oil.
Table 1: Non-OPEC Upstream Oil Projects Pipeline, kb/d, 2016 (more than 25 kb/d)

4
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of the Oxford Institute for Energy Studies or any of its Members.

Table 2: Non-OPEC Upstream Oil Projects Pipeline, kb/d, 2017 (more than 25 kb/d)

Source: Energy Aspects.

Thus the low oil price does not have an immediate impact on supply; given the two characteristics of
the non-OPEC investment cycle, the effects are filtered through its impact on investment, with all the
associated lags. As in other cycles, the industry has reacted to the decline in the oil price by cutting its
investment sharply. For two consecutive years (2015 and 2016) oil companies have implemented
large cuts in capital expenditure (Table 3). The IEA has recently warned of a worst-case scenario,
which will see a third year of spending cut in 2017.5
The impact on oil supplies of these sharp cuts in investment has been two-fold. Many projects which
would have boosted future supplies have been cancelled. Cases in point are seen in Brazil and
Canada. These two countries, which have long been considered as key centres for future supply
growth outside OPEC for the next decade, have revised downwards their long-term production
targets. Brazil has reduced its capex and revised downward its production target from 4.2 to 2.7 mb/d
of liquid production by 2020.6 Canadas oil production has been revised downward substantially as
many projects have been postponed or cancelled. The Canadian Association of Petroleum Producers
still projects for total Canadian production to grow from 3.7 mb/d in 2014 to 5.3 mb/d in 2030, but this
is 1.1 mb/d lower than their 2014 forecast.7
The UK Continental Shelf (UKCS), one of the most mature oil provinces, is another case in point.
Benefiting from a massive investment programme in the high oil price environment, the UKCS was
able to reverse the decline in its output, registering a year-on-year growth in both 2014 and 2015, and
it will most likely achieve a similar fate in 2016 (Figure 5). However, as the pipeline of new projects
starts slowing down (in 2015, field development plans have fallen sharply), the new fields will not be
able to offset the decline rates and by the end of this decade, UK North Sea output is expected to
decline. The sharp decline rates in Mexico (Figure 6) are a reminder of the production profile of a
mature area which fails to implement a sufficiently large investment programme.

The cuts have not been only been limited to capex budgets, but also exploration budgets which have taken a huge hit.
Morgan Stanley has recently noted that oil discoveries in 2015 fell to their lowest level since 1952.
6
Wall Street Journal, Brazils Petrobras Slashes Investment Budget for Second Time, 12 January 2016.
7
Canadian Association of Petroleum Producers, 2015 CAPP Crude Oil Forecast, Markets & Transportation. CAPP projects for
total Canadian production to grow from 3.7 mb/d in 2014 up to 5.3 mb/d in 2030, which is 1.1 mb/d lower than 2014 forecast.

5
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of the Oxford Institute for Energy Studies or any of its Members.

Table 3: Global Capex Estimates, $ billion

Region

2016E

2015E

2014A

+/

72.2

114.6

158.1

(42.3)

(36.9%)

8.5

13.6

21.0

(5.1)

(37.5%)

Canada

22.4

30.1

36.8

(7.7)

(25.5%)

Mexico

14.5

18.0

24.6

(3.5)

(19.4%)

Asia Pacific

78.7

96.2

116.9

(17.5)

(18.2%)

International

77.3

95.7

107.5

(18.4)

(19.3%)

Russia/FSU

37.9

33.2

43.9

4.6

13.9%

Latin America

35.7

47.8

53.2

(12.1)

(25.3%)

Europe

27.6

34.5

45.1

(6.9)

(19.9%)

Middle East

37.0

39.9

40.7

(2.9)

(7.3%)

Africa

16.5

20.1

23.0

(3.6)

(17.8%)

Other

8.0

10.7

10.4

(2.7)

(25.0%)

0.0

0.0

0.0

0.3

0.4

0.5

(0.1)

(15.7%)

436.4

554.4

681.1

(118.0)

(21.3%)

United States
US
Independents
Intn.

Majors

International
Global Capex

Source: Energy Aspects.

Figure 5: UK Liquid Production, mb/d (201016)

Source: DECC.

Figure 6: Mexico Oil Production, mb/d

Source: PEMEX.

Thus the other impact filtering through into oil supplies is the lack of investment in existing fields,
which can accelerate decline rates, especially in mature fields. Even before the fall in the oil price, the
IEA has estimated an average decline rate of 6.2 percent per year for fields that have passed their
6
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

peak, with offshore fields (especially in deepwater) showing faster decline rates than onshore fields
and non-OPEC fields declining faster than OPEC fields, mostly because of the different mix of fields.8
For instance, Brazil continued to increase its output year-on-year in 2015. But the aggregate figures
hide some interesting dynamics. While Brazils sub-salt output has increased, production from mature
fields has been declining at alarming rates (Figure 7). Similarly, while output from Canadas oil sands
has been increasing, conventional production continues to decline (Figure 8). This explains why,
despite the start of many projects in 2016, output in these countries has already fallen year-on-year in
the first quarter of 2016.
Figure 7: Campos vs. Santos production, y/y, mb/d

Campos

0.5

Figure 8: Canadian Production by Type, y/y, mb/d

Santos

0.3
0.1
(0.1)
(0.3)
12

13

14

15

16

Source: ANP.

Source: NEB.

Non-OPEC supply in other mature areas of the world has also been in decline. Chinas crude oil
production has fallen sharply in recent months due to investment cuts and the reorganization of the oil
sector (Figure 9). In Colombia, lower investment, sharp declines in rig count, and disruptions have
also resulted in output falls (Figure 10).
Figure 9: China Crude oil output, mb/d

Figure 10: Colombia Crude oil output, mb/d

Source: China Customs, NBS.

Source: Colombian Ministry of Mines & Energy.

See Kemp, J (2015), Decline rates will ensure oil output falls in 2016 Reuters, Sep 15.

7
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

In short, the non-OPEC supply response outside US shale seems to exhibit all the cyclical elements
that characterized previous cycles:

The long investment cycle with high capital intensity implies that non-OPEC
supply will respond to prices but with lags;

This time round the lags seems to be relatively shorter, with the impact already
being felt on supplies, and all international energy agencies are projecting yearon-year declines in 2016 in non-OPEC outside the USA (see Figure 3);

These decline rates will only accelerate in coming years as the pipeline of new
projects starts slowing down drastically;

While the oil industry is currently benefiting from the low cost of oilfield services,
as some companies successfully renegotiated contracts with service providers
and managed to reduce costs, these costs will increase as activity starts picking
up (also if currencies start appreciating).9 There is no strong evidence so far to
suggest that the cost reduction is fully structural, though the overcapacity in
some segments of the industry, especially in deep offshore10, may imply that
the cost of some oilfield services will lag the rise in oil price, but this does not
apply to all parts of the supply chain.

2.2 US shale output

The main reason why many analysts think that this cycle is different and cant be simply analysed as
yet another cycle is US shale. The size of the US oil supply shock has been nothing short of
phenomenal. From a position of negative growth in 2008, US crude oil production growth turned
positive in 2009 and amounted to 840,000 b/d in 2012, 950,000 b/d in 2013, and 1.25 mb/d in 2014.
This achievement is remarkable by any standard. In addition to constituting a supply shock and
altering crude oil and products trade flows, the USA is widely believed to have altered the nature of
the investment cycle in the oil industry in a number of ways:

Length of the investment cycle. The time lag between Final Investment Decision
(FID) and first production is a fraction of that for conventional or deep offshore
fields11;

Capital intensity. The capital investment required to bring a new shale well into
production is a fraction of the cost of conventional or deep offshore wells;

Production profile. While it is cheaper to develop shale wells, the volume

production from these wells is low compared to offshore fields. In order
achieve levels of production similar to those of offshore fields, the number
shale wells needed to be brought on stream is in the thousands, compared
just a few in deep offshore (Figure 11);

Decline rates. These are much higher in shale wells estimated to be around
70 per cent in the first year of production (Figure 12). This implies that the only

of
to
of
to

A substantial part of the cost deflation is due to the depreciation of the currency. Particularly, companies that operate in
countries which pay for the bulk of their services in local currency such as in Canada or Russia tend to benefit the most from
this foreign exchange effect. As currencies appreciate, some of these cost reductions will fade. For instance, the Russian
currency has already strengthened amid growing oil prices.
10
Cuvelier, C., L. Di Fiori, and M. Brinkman (2015). Offshore floating rigs from bad to worse, McKinsey Energy Insights, May.
11
Goldman Sachs estimates that for the US shale, the time to market is around seven months and the payback period of
around 18 months vs. 3-4 years from FID to production in conventional projects and a typical payback period of 7-8 years. See
Goldman Sachs, Top Projects 2016, May 2016.

8
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of the Oxford Institute for Energy Studies or any of its Members.

way to increase production and offset the impact of decline rates is to bring more

and more new wells into production;

Dependence on capital markets. US shale firms are highly leveraged and are
therefore heavily exposed to changes in credit market conditions, particularly
the availability of credit. This represents a fundamental shift from previous
cycles, in the sense that any deterioration in credit market conditions can have a
direct impact on oil production. Even in a high oil price environment, cash flows
from operations have been too small to cover capex, with the shortfall having
increased in recent years. The shortfall has been financed mainly by debt, and
as a result the leverage of US shale producers has risen sharply over the years,
with debt service as a share of operating cash flow reaching very high levels.12

Figure 11: Bakken vs. pre-salt well count

Source: Energy Aspects.

Figure 12: Average Oil Production per well, b/d

Source: EIA.

US shale: what resiliency?

As in other parts of the world, the US shale industry responded to the sharp decline in oil prices by
cutting investment severely and shedding rigs (Figure 13). Despite the talk of US shale resilience,
the impact on output has been dramatic. From growth of 1.25 mb/d in 2014, crude oil output growth
kept declining in 2015 and in December 2015, US year-on-year output growth turned negative despite
the production increase in the Gulf of Mexico (GOM) (Figure 14). The financial health of the US shale
industry deteriorated, with many firms declaring bankruptcy. Huge adjustment, the full repercussions
of which are not yet fully understood, is currently taking place in the US shale industry. For instance,
Reuters has recently noted that
... the rout in crude prices is snowballing into one of the biggest avalanches in the history of corporate
America, with 59 oil and gas companies now bankrupt after this weeks filings for creditor protection by
Midstates Petroleum and Ultra Petroleum. The number of U.S. energy bankruptcies is closing in on the
staggering 68 filings seen during the depths of the telecom bust of 2002 and 2003.13

12

The EIA estimates that for the four quarters from 1 July 2014 to 30 June 30 2015, 83% of shale companies' operating cash
was being devoted to debt repayments. The EIA notes that as the share of debt repayment to operating cash flow increases, a
company is left with less cash to use for investment opportunities, dividends, or savings for future use. EIA (2015), Debt
service uses a rising share of U.S. onshore oil producers operating cash flow, Today in Energy, September.
13
Reuters, U.S. oil industry bankruptcy wave nears size of telecom bust, 4 May 2016.

9
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of the Oxford Institute for Energy Studies or any of its Members.

Figure 13: US Rig Count

Figure 14: US Crude Oil, y/y, kb/d

1400
1200
1000
800
600
400
200
0
-200
-400

Source: EIA.

Perhaps some were expecting larger declines in US output than those currently observed, and even
deeper restructuring in the US shale industry. So why did US shale defy the expectations of faster
declines?

The relationship between the fall in the number of rigs and the fall in production
is not linear. The distribution of rig productivity is highly skewed, with lower
yielding rigs being shed first and remaining rigs being targeted towards the more
productive sweet spots; the fall in output will hence not mirror the decline in the
number of rigs.

Given the nature of the investment cycle and the resource base, the room for
achieving efficiency gains has been high. Over the last few years, US shale has
managed to achieve large efficiency gains which have allowed it to squeeze
towards the middle of the cost supply curve. 14 This is fundamentally different
from the mid 1980s, when the new sources of supply came from high-cost
producers such as the UK, Norway, and Mexico.

An important part of the resilience story is the ability of the US shale producers
to squeeze service providers and reduce their own costs by shifting part of the
pain to oilfield service providers.

As in other parts of the globe, US shale producers have retreated to their core
assets, thus increasing the efficiency of their production; this is partly reflected
in their higher IP (initial production) rates.

Many US shale producers benefited from the high oil price environment and
hedged their production. Such hedges prevented rapid deterioration in their
financial health.

14

For instance, Goldman Sachs estimates that the average US shale oil breakevens have fallen from above US$80/barrel in
2014 to around US$55/barrel in 2016. The report predicts that with well productivity still improving by 3%-10% per annum in
major basins, this could fall to around US$50/barrel by 2018. See Goldman Sachs, Top Projects 2016, May 2016.

10
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of the Oxford Institute for Energy Studies or any of its Members.

Due to these factors (which are not all related to efficiency or drastic improvement in technology), US
shale output did not decline as fast as many were expecting. But declines did occur and the industry
is currently undergoing a major restructuring. In other words, US shale supply did prove to be
responsive to lower oil prices, but the supply response was perhaps not as big or as quick as many
were originally expecting.
More resilience on the upside?
Although the US shale supply response has not proved to be highly elastic in the downward phase,
will this also apply to the upward phase of the cycle? A fundamental element in the stories of lower
for longer and the end of the super cycle is that as soon as oil prices rise, the US shale supply
response will be strong enough to cap any upside potential.
This is perhaps one of the key uncertainties surrounding the current price cycle and one of the issues
that divides analysts. Those who think that US shale is highly responsive tend to support their view by
pointing out:
(i)

the large number of drilled but unfracked wells (DUCs) which can be brought quickly into
production;

(ii)

the nature of the investment cycle, which is short term;

(iii)

the low capital intensity of new wells;

(iv)

the availability of finance, especially in this low interest rate environment, where investors
are seeking high yields;

(v)

the flexibility of the service industry which is able to respond to increasing demand in an
efficient and speedy way.

For those who are less optimistic, there are many reasons why the US shale response may be
sluggish even in a high oil price environment. These include:
(i)

restricted availability of finance as US shale is no longer seen as growth industry but as a

boom and bust industry; this will affect the appetite for financial investors to fund shale
firms;

(ii)

the service industry has lost much of its flexibility (especially due to loss of human
resources but also as investment in new equipment has fallen sharply) over the last couple
of years and hence may not respond as quickly as currently anticipated, and if it does, it
will do so by increasing the cost of its services;

(iii)

while the DUCs can be brought quickly into production, the impact on supplies is short
lived, especially because the number of DUCs has already been falling;

(iv)

when oil prices rise, firms will have to move away from core areas to non-core areas,
reducing their efficiency and increasing their cost structure;

(v)

the more consolidated shale sector will operate within a stricter capital discipline, which
will affect the rate at which these firms grow their output.

Which of these views is likely to prevail? The response could fall between these two extremes: the
price needed to reverse the decline in US shale production is likely to be higher than currently
anticipated and while US shale will respond to higher prices, the ramp up in supply will be slower, and
the supply gains will probably be more modest than in the boom years. In other words, as in the
downward phase, the US supply is likely to prove elastic, but much less so than many are currently
predicting. The switch-on-switch-off comparison simply does not hold.

11
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of the Oxford Institute for Energy Studies or any of its Members.

2.3 OPEC dynamics

OPEC behaviour has always been key for oil market adjustment and this time is no different. Cuts by
producers (and supply disruptions) still constitute the quickest mechanism that feeds directly to oil
market balances. In 2015 OPEC was the major source of supply growth, with Iraq and Saudi Arabia
alone increasing their output by 1.1 mb/d (Figure 15). In other words, not only did OPEC fail to
balance the market by not cutting supplies, but its members increased their output and added to the
over-ground inventories. Looking ahead into 2016, while non-OPEC production (both within and
outside the USA) is expected to decline, the major source of uncertainty on the supply side remains
OPEC, particularly just how fast and by how much Iran can increase its production after the lifting of
sanctions (Figure 16) and how Saudi Arabia will respond to the increase in Iranian exports.
Figure 15: Key Areas of Growth in OPEC, y/y kb/d, 2015

Figure 16: Iran Oil Production, mb/d

700
600
500
400
300
200
100
0

Iraq

Saudi Arabia

Angola

UAE

Source: MEES, Energy Aspects.

The sole swing producer that never was

Saudi Arabia has repeatedly emphasized that it will not cut output unilaterally. Indeed, given the
events that followed the price collapse in 1985, the Kingdom has little incentive to act as the sole
swing producer.
Between 1973 and 1985, OPEC exercised ultimate pricing power by setting the marker price, but in
doing so had to live with variable production volumes. With a continued decline in demand for its oil,
OPECs share in world production fell from 51 per cent in 1973 to 28 per cent in 1985. Under this
pressure, disagreements began to surface. Saudi Arabia lost market share with every increase in the
marker price and hence opposed price increases. Other OPEC members pushed for large price
increases while at the same time putting additional oil in the market in an attempt to boost revenues.
OPECs introduction of a formal quota system proved to be ineffective in preventing production from
rising above quotas (in other words, cheating) and it was clear by the mid-1980s that OPEC was
losing its power to set the oil price. Saudi Arabias attempts to defend the marker price resulted in a
huge loss of market share: the demand for Saudi oil declined from 10.2 mb/d in 1980 to 3.6 mb/d in
1985 (Figure 17). This decline in production volumes and loss of market share proved to be very
costly for the Kingdom, which decided to abandon the administered pricing system in 1985, allowing
the country to recover its lost share through the netback pricing system.

12
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of the Oxford Institute for Energy Studies or any of its Members.

Figure 17: Saudi Arabia oil production, kb/d

Figure 18: Saudi Arabia production vs quota (kb/d)

14,000
12,000
10,000
8,000
6,000
4,000
2,000

Source: BP.

2014

2010

2006

2002

1998

1994

1990

1986

1982

1978

1974

1970

Source: OPEC.

Saudi Arabia reacted in a similar manner in 1997, in response to Venezuela increasing its productive
capacity and production above its allocated quota. Rather than cutting production, Saudi Arabia
produced over its allocated quotas (Figure 18) and in the face of the Asian financial crisis, oil prices
collapsed. It took many months for producers to reach an agreement and this happened only after
both OPEC and non-OPEC members agreed to cut collectively. In the current cycle, Saudi Arabias
position has not changed. Only recently, the new Saudi Minister of Energy, Industry and Mineral
Resources Mr Khalid Al-Falih reiterated this position, arguing that Saudi Arabia
... is not going to withdraw production to make way for others. If other producers are willing to collaborate,
Saudi Arabia is willing to collaborate. But Saudi Arabia will not accept the role, by itself, of balancing a
structural imbalance.15

Within OPEC, the quota system remains the only mechanism to regulate output levels. But this
mechanism rarely works, especially when the market is oversupplied (that is, when the quotas are
mostly needed to balance the market). Even if there is an agreement between members on the
volume of the cut that is required to support prices, assigning quotas for individual countries has
proven to be difficult over the years. Previous efforts to design a system of allocating quotas that is
equitable to all members and based on formulae that incorporate objective criteria (such as the size
of the reserves, the production capacity, historical production share, domestic oil consumption,
production costs, dependency on oil exports, the size of the population, and external debt) have not
worked. But even if there is an agreement on such formulae to allocate individual quotas, OPEC does
not have formal monitoring mechanisms in place, and hence violations are usually not detected
instantly. Even if violations were detected, OPEC does not have the formal enforcement mechanisms
which would allow it to punish member countries or to force them to abide by the agreed quotas.
In the current context, agreeing on individual quotas has become increasingly difficult. Iran and Iraq
both have ambitious plans to increase output and will consider any reintroduction of individual quotas
as a key impediment to achieving these targets. Both countries feel that Saudi Arabia has benefited
from the disruptions in their oil exports over the years and hence the Kingdom should make space for
their crudes. Libya is also a special case as it is suffering from large disruptions and thus expects to
be exempt from any individual quotas. But Saudi Arabias experience is more shaped by the events of
198616 and it is in no mood to allow for exceptions.

15

The Telegraph, No end to oil rout as Saudi Arabia plays tough, 21 January 2016.
The ex-Saudi Oil Minister Ali Al-Naimi expressed his concerns about such a scenario stating that the experience of the first
half of the 1980s was still in our minds. At the time, we cut our production several times. Some OPEC countries followed our
lead, and the aim was to reach a specific price that we thought was achievable. It didnt work. In the end, we lost our customers
and the price. The Kingdoms production dwindled from over 10 mb/d in 1980 to less than 3 mb/d in 1985. The price fell from
16

13
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of the Oxford Institute for Energy Studies or any of its Members.

The only interruption to this policy was the output freeze deal discussed in Doha in February 2016. As
argued by Fattouh et al. (2016),17 the impact of the freeze agreement on market balances would have
been negligible, but the Doha communiqu mattered because
... it did not focus on market share maximization and leaving it completely to the market to rebalance, but
was in contrast more accommodating and hinted at further proactive steps being taken, should they be
needed. (Fattouh et al., 2016)

This impacted market sentiment and provided some support for the oil price. However, the failure to
reach an agreement in Doha in April of this year reinforced the view that producers cooperation cant
be relied on to rebalance the market; on the contrary, there are growing concerns that the political
rivalry between Iran and Saudi Arabia will translate into more fierce competition for market share,
dampening any price recovery.18
US shale and Saudi oil policy: policy in face of structural uncertainty
But putting aside inter-OPEC dynamics, Saudi Arabia also faces some structural changes in the oil
market, which complicate its output policy decision. With the advent of US tight oil, OPEC and Saudi
Arabia have entered uncharted territory; they are still learning about this new source of supply and its
responsiveness to price signals. While there is a better understanding about how US tight oil reacts to
falling oil prices, big uncertainties remain as to how fast US tight oil production can respond to higher
prices, and at what price level US shale output growth will return. Fattouh et al. (2015)19 modelled
Saudi Arabias short run strategy by using a simple strategic game. The game has two players: Saudi
Arabia and the rest of OPEC. It is divided into two identical simultaneous games in order to account
for the effect of US shale oil and its associated uncertainty. This uncertainty pertains to supply curve
elasticity, which is assumed to be either elastic or inelastic.
Game 1

When the shale oil supply curve is highly elastic (game 1) there is a dominant strategy
for both Saudi Arabia and other OPEC players. Saudi Arabia would be better off not
changing its output, irrespective of the behaviour of the rest of OPEC. The same
applies to other players. Thus, the game has a single optimal strategy: no player
changes its output level because it would lose both market share and revenue (Table
4).

Game 2

When the shale oil supply curve is highly inelastic (game 2), there is a strictly
dominant strategy for the Kingdom. In the short term, Saudi Arabia benefits from an
output cut irrespective of the behaviour of the rest of OPEC. There is also a dominant
strategy for other suppliers: cutting output leaves them a level of gain higher than
inaction, no matter what Saudi Arabia does. Therefore, under game 2, there is a
single optimal strategy profile Saudi Arabia should opt for an output cut with or
without coordination from other members (Table 4).

over $40 per barrel to less than $10. We are not willing to make the same mistake again. See https://enmaktoob.news.yahoo.com/full-text-saudi-oil-ministers-speech-riyadh-084034690--business.html.
17
Fattouh, B., J. Henderson, and A. Sen (2016). SaudiRussia Production Accord: The Freeze before the Thaw?, OIES
Energy Comment, February.
18
For instance, in a recent report Citi noted that Chance of Saudi boost is primary impediment or risk to oil prices surging
much beyond $50/bbl near-term.
19
Fattouh, B., A. Sen, and R. Poudineh (2015). The Dynamics of the Revenue MaximizationMarket Share Trade Off: Saudi
Arabias Oil Policy in the 20142015 price fall, OIES Paper WPM61, October.

14
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

Table 4: Game under certainty

Elastic US supply
(Game 1)

Inelastic US supply
(Game 2)

Other-OPEC
Other-OPEC
members do
members
not change
cut output
output
Saudi Arabia cuts
output

C, C

Saudi Arabia does

not change output

0, A

Other-OPEC Other-OPEC
members cut members do not
output
change output

A, 0

Saudi Arabia cuts

output

A,

C, B

0, 0

Saudi Arabia does

not change output

B, C

0, 0

Source: Fattouh et al. (2015).

Note: The ranking of payoffs is such that C<B<A.

The problem is that at the time of decision, no complete information regarding the elasticity of the
shale supply curve is available to the players. Put another way, there is no way for any of the players
(including Saudi Arabia) to find out which game they are in a priori. In fact, whether they are in game
1 or game 2 will only be revealed after the players have implemented their strategy. If the players
knew in advance which game they were in, then the problem would be simple. However, due to
uncertainty the players are exposed to significant risk because four different possibilities exist:

Saudi Arabia might be in game (1) and plays as if it is in game (1).

Saudi Arabia might be in game (1) but plays as if it is in game (2).

Saudi Arabia might be in game (2) but plays as if it is in game (1).

Saudi Arabia might be in game (2) and plays as if it is in game (2).

Taking into account all these possibilities, Fattouh et al. (2015) find that under uncertainty it is always
better for Saudi Arabia to assume that it is in game 1 as long as there is no information available a
priori (Figure 19). In other words, under uncertainty it is always safer for the Kingdom to assume that
shale oil supply is elastic and pursue no change in output policy.20 As Saudi Arabia learns more about
this new source of supply, its policy could adapt accordingly. This highlights the importance of relying
on dynamic models that allow for changes in Saudi Arabias behaviour. Attempts to fit Saudi Arabia
into a particular category have failed in the past and would most likely fail in the future, as its output
policy is constantly evolving.

20

While the game is played along one dimension of uncertainty (the elasticity of the US supply curve), the range of
uncertainties facing Saudi Arabia is quite wide, from the speed and the volumes that Iran can put in the market to the efficiency
gains and cost deflation achieved by the industry during the downturn.

15
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

Figure 19: Game under uncertainty

Source: Fattouh et al. (2015).

The quest for market share

For now, Saudi Arabias output policy seems to focus on market share. There has been a debate
among economists about the intrinsic value of market share as an economic objective. It is possible to
identify three reasons as to why Saudi Arabia may wish to pursue market share. First, Saudi Arabia
holds 267 billion barrels of proven reserves, with a reserve-to-production ratio of more than 63 years.
Therefore, securing markets for its oil is a key long-term policy objective. In other words, while
revenue maximization constitutes a key policy objective, the time horizon over which revenues should
be maximized also matters. Second, when it is difficult to reach an agreement within OPEC on a
collective cut, Saudi Arabia can maintain or even increase its market share, pushing prices down and
reducing the revenues for all other oil producers in an attempt to get other producers to cooperate.
Third, pursuing market share can act as a deterrent strategy to squeeze high-cost competitors out of
the market. Also consistent with this strategy, Saudi Arabia can abandon its role as market stabilizer
in an over-supplied market, inducing more price volatility and sharper price movements. Increased
volatility, together with the perception that prices could fluctuate within a wide range, might cause
investors to reassess the risks in new energy projects. This would increase the value of the option to
wait and discourage investment in new oil projects.21
The loss of a key feedback mechanism
One of the distinguishing features of the current price fall is the low probability that the market
attaches to any form of cooperation between producers to clear the market. OPEC behaviour over
this cycle has been different from that seen in several previous cycles and this represents a structural
shift in the market adjustment mechanism. In 2008, the global financial crisis resulted in large drop in
oil demand. OPEC reacted to this temporary decline by sharply cutting output, which proved effective:
the V-shaped recovery of the global economy meant that oil demand quickly recovered and OPEC
was able to raise its output and meet the increase in demand. In 1998, the drop in demand due to the
Asian financial crisis and Venezuelas drive to maximize production posed a major challenge for
OPEC. Both of these factors eventually reversed, with oil demand recovering as Asian economies
emerged from the financial crisis, and Venezuelan production declining after Chavez assumed power.
Although it took a long time for OPEC and non-OPEC members to reach an agreement on an output
cut, the 1998 crisis reasserted OPECs role in the market. In contrast, in 1986, the decline in demand,
the increase in non-OPEC supply, and lack of cohesion within OPEC resulted in a collapse of the
OPEC administered pricing system and the emergence of a new pricing structure in which OPECs
21

In 2015 the new Saudi Energy Minister Mr Al-Falih noted that the past willingness of Saudi Arabia in particular to limit output
to defend high oil prices was a mistake that had only served to spur high-cost output elsewhere. Such a policy had offered high
cost producers an insurance policy of $100 oil a guarantee of no risk for investment.

16
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

role was diminished over subsequent years. The low-price environment persisted for the rest of the
1980s and 1990s.
In the current cycle, the lack of cohesion within OPEC, the abandonment of the OPEC quota system
and output ceilings, OPEC members policy of maximizing output in an attempt to increase revenues,
and the structural uncertainties facing OPEC have all contributed to OPEC abandoning its role in
balancing the market and therefore a key adjustment mechanism has been lost. If there is no quick
mechanism to balance an oversupplied market, the market can only restore balance through demand
and supply adjustments responding to price signals.

3. The Demand Response in a Low Price Environment

With adjustment on the supply side showing more complex dynamics non-OPEC production falling
but OPEC producers maximizing their output in an attempt to boost revenues adjustment on the
demand side has been key to rebalancing the market. How did oil demand growth react to the drastic
fall in the oil price? To answer this question, it is important to emphasize the following two points.
First, the sources of demand growth have become more varied and demand growth is no longer just
about China. In 2015, other areas/countries made major contributions to oil demand growth. Second,
the focus should not be only on diesel demand growth; most of the growth in the last few months has
been concentrated on gasoline and the light end of the barrel. For instance, in China, gasoline
demand has outperformed that of diesel as the economy continues to rebalance from investment
towards consumption (Figure 20).
Figure 20: Chinas diesel/gasoline demand, mb/d

Figure 21: Global Oil Demand, y/y change, kb/d

2,500
2,000
1,500
1,000
500
--

Source: Energy Aspects.

Source: China Customs, NBS.

Overall, oil demand growth was quite strong in 2015, with global oil demand growing at around 1.8
mb/d, well above its long-term historical trend (Figure 21). While part of that increase in demand has
found its way to storage, with countries like China and India taking advantage of cheaper crude to fill
their strategic reserves, end-product demand (where there is less storage capacity) also points to
strong demand growth. This suggests that despite the low price elasticity of demand, the sharp
decline in the oil price has had its impact on demand, both through price and income effects. In
countries like the USA, where taxes on petroleum products are low, the impact has been more visible;
gasoline consumption has risen quickly as US motorists are driving more and opting for larger
vehicles (Figure 22). In India, gasoline sales have seen a sharp rise (almost doubling from the 2009
level) and in 2015 India made a larger contribution to global oil demand growth than China (Figure
23).22
22

See Sen, A. and A. Sen (2016). Indias Oil Demand: On the Verge of Take-Off?, Oxford: Oxford Institute for Energy Studies.

17
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

Figure 22: US Gasoline Demand, kbd

Figure 23: Indias Oil Demand, y/y growth, mb/d

9400
0.7

9200
9000

0.5

8800
0.3

8600
8400

0.1

8200

(0.1)
10

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

8000

Source: EIA.

11

12

13

14

15

16

Source: PPAC.

The strong growth performance of 2015 is not likely to be repeated in 2016. As the global economy
slows down, oil demand growth will also slow down but still demand is projected to grow at above 1
mb/d in 2016 although there is a lot of variation across countries (Figure 24). In some of the countries
whose growth prospects have been revised sharply downwards, such as Brazil, we are witnessing
year-on-year declines, with diesel demand in these countries taking the biggest hit (Figure 25).
Figure 24: Growth in Demand, y/y mb/d
Japan

2016

Brazil

2015

Figure 25: Brazilian Oil Demand, y/y, mb/d

Russia
Saudi
China
India
US
Europe
Other Asia
(0.2) (0.1)

0.0

Source: Energy Aspects.

0.1

0.2

0.3

0.4

0.5

Source: ANP.

In short, as expected, oil demand did respond to lower oil prices in 2015, but weaker global growth
prospects will most likely cause demand to slow down in 2016. But this creates a puzzle: Why didnt
the sharp declines in the oil price induce a stronger rebound of the global economy? After all, it is not
very long since a high oil price was considered to be one of the main threats to the stability of the
global economy. However, some recent commentary is suggesting that very low oil prices are also not
good for the global economy.
The current oil price shock has resulted in a large transfer of income from oil exporters to oil
importers. Even if this wealth has not been transferred directly to motorists in oil importing countries
through, for instance, lower gasoline prices (due to governments cutting subsidies or increasing taxes
on petroleum products), it would have filtered through other indirect channels such as increased
government spending and more robust public finances. Although the losses and gains of such wealth
transfer sum to zero, the increase in spending by oil importers due to the windfall is likely to exceed
the decline in spending by exporters. Furthermore, in sectors where oil is an input, lower production
18
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of the Oxford Institute for Energy Studies or any of its Members.

costs will help stimulate supply. So the net effect of lower oil prices should be positive for the global
economy.
One could argue that the low oil price has had a positive impact on the global economy, but the
impact has been mitigated by a number of offsetting factors. First, it is possible that
consumers/government in oil importing countries have been partly saving the windfall. Second, unlike
previous cycles, many of the oil exporting countries have responded to low oil prices by rationalizing
spending and introducing painful reforms. Third, the deep cuts in investment in the oil and gas
industry have had a negative impact on GDP growth through the investment channel.23 Finally, some
have suggested that low oil prices have contributed to deflationary pressures, increasing the cost of
capital and stifling investment. In other words, in a deflationary world, low oil prices could does not
necessarily generate the positive income effect. 24

4. Oil Prices: Lower for Longer Or Higher Sooner Than Later?

Currently, there are two views dominating the oil market discourse. There are those who strongly
believe that the market has undergone structural changes and that low oil prices are here to stay for a
prolonged period. At the other end of the spectrum, there are those who think that this is yet another
cycle and oil prices will recover sooner rather than later. These two scenarios structural versus
cyclical reflect the high degree of uncertainty engulfing the oil market.
Oil prices lower for longer?
It is quite important to be clear about what the phrase lower for longer really means. First, lower
signifies that oil prices are lower than they have been in the past. But which two periods are we
comparing? Perhaps the basis for comparison here would be the $100 plus oil price environment
between 2010 and mid-2014. Compared to that base, oil prices are certainly lower. In January 2016,
the oil price fell to below $30 per barrel, but since then prices have recovered. Compared to that base,
oil prices are now higher!!! One would assume that the lower price refers to a range (higher than $30
and lower than $100), which is not very useful. The concept of longer is also confusing. It refers to an
extended period of time, though this remains undefined. Perhaps this catchphrase refers to a
scenario in which the oil price has moved into a new lower equilibrium (and hence the lower) but this
equilibrium is unstable and there are forces that will continue to push this equilibrium lower over time
(and hence the longer).
The case of oil prices being lower for longer in the way defined above is based on a number of
premises including:

Demand growth will ease due to lower economic growth (secular stagnation)
and/or climate change policy;

OPEC is no longer functional and rather than balancing the market, OPEC
producers will aim to maximize production and compete for market share;

US shale would respond quickly in a higher oil price environment, putting a cap
on the oil price;

The structural imbalance in the market resulted in a high level of crude and
products stocks which would also play a stabilizing role;

23

For instance, Obtfeld et al argue that the decline in investment in energy and mining (and related industries) has played an
important role, with a notable downward revision to investment growth in commodity-exporting advanced economies but also
the unexpectedly large decline in US energy-related investment noted above. And, at the same time, there has been no
discernible boost to investment outside the oil sector, contrary to what was expected. Obstfeld, M., G.M. Milesi-Ferretti, and R.
Arezki (2016). Oil Prices and the Global Economy: Its Complicated, IMF Direct. https://blog-imfdirect.imf.org/2016/03/24/oilprices-and-the-global-economy-its-complicated/.
24
Obstfeld, M., G.M. Milesi-Ferretti, and R. Arezki (2016). Oil Prices and the Global Economy: Its Complicated, IMF Direct.
https://blog-imfdirect.imf.org/2016/03/24/oil-prices-and-the-global-economy-its-complicated/. In the authors words, when an oil
importers macroeconomic conditions warrant a very low central bank interest rate, a fall in oil prices could move the real
interest rate in a way that runs counter to the positive income effect.

19
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

The current cost deflation in the industry is structural;

The efficiency gains achieved in US shale will continue and will spread to other
parts of the supply chain.

One of the key premises underlying the view of oil prices being lower for longer is that oil demand
growth will slow down permanently; this could be due to a grim view on the global economic outlook
and/or due to climate change policies. It is assumed that climate change policies would decouple oil
demand growth from economic growth and from oil price behaviour because of huge improvements in
efficiency and changes in the fuel mix (such as changes in the transport sector, as natural gas
vehicles and electric cars make inroads into the transport sector). But this story on demand needs to
be combined with one on the supply side for the above scenario to be consistent with the lower for
longer view. Due to the projected lower oil demand, the industry does not need to develop its most
costly reserves (Arctic, deep offshore). This factor would have the effect of reducing the average cost
for the industry. Also, US shale will play an important role in satisfying demand on the margin, and
given that this segment of the industry has shown the greatest improvements in efficiency, the cost
structure for the industry as a whole will fall further, especially if some of these efficiency gains are
transferred to other parts of the supply chain. Finally, the fact that OPEC will no longer play the
stabilizing role, and instead will aim to maximize production, will mean that low-cost producers will
further push out high-cost producers. In such a world, overcapacity in the service sector will persist
and service companies will lose the power to capture a larger part of the rent by increasing their
prices.
It is clear from this scenario that US shale will set the ceiling for the oil price (which is assumed to be
much lower than $100 per barrel) and the efficiency gains achieved will continue to shift the
equilibrium price downward. This scenario somehow predicts smoother cycles around a declining
trend, with US shale acting as a stabilizer on the upside and oil-exporting countries having little choice
but to adjust their spending to a lower-price environment.
What circumstances could disturb this scenario? One key factor is the pace of oil demand growth.
Despite the decline in oil intensity of the worlds GDP, income effects remain strong, especially in
developing countries where car ownership remains at very low levels.25 In fact, various projections
have shown that even with huge improvements in efficiency and drastic changes in the energy mix,
the demand for energy will continue to increase in absolute terms. Even when assuming huge
improvements in efficiency (higher than those experienced in the period 19942014, which saw some
of the biggest improvements in global energy intensity) and changes in the fuel mix, energy demand
(including oil demand) is projected to increase from now until 2035.26
Another factor is the US shale response. As discussed above, there is wide uncertainty regarding US
shale supply response in a rising price environment and whether the underlying reserve base is large
enough to offset the declines from non-OPEC and other producers, and sufficient to meet the
expected rise in demand. If US shale cant carry the entire load and low cost producers in OPEC are
not able to meet the demand, serious cracks in this scenario will become visible as costlier projects
may be needed to meet demand, and cost inflation will start creeping into the industrys cost curve.
In fact, there may be a case for OPEC producers with a large reserve base (read Saudi Arabia) to
play a more proactive role on the upside. One of the lessons for Saudi Arabias policy makers from
the latest cycle is that a high oil price environment will accelerate supply and demand responses,
especially as environmental concerns intensify; therefore in the long term, it is in the Kingdoms
interest to prevent prices from rising to high levels, putting a cap on the oil price. To achieve this,
Saudi Arabia would need to invest in new productive capacity and maintain spare capacity and
25

IMF (2016), Special Feature: Commodity Market Developments and Forecasts, with a Focus on the Energy Transition in an
Era of Low Fossil Fuel Prices Commodity, World Economic Outlook, IMF, April. The IMF notes that on the demand side, lower
GDP growth in emerging markets has tended to reduce oil demand growth, especially in light of the secular increase in global
oil efficiency, and is expected to continue to do so. That said, the expansion of the middle class in emerging giants is expected
to increase dramatically the demand for transport services and the level of car ownership and, in turn, to support oil demand
growth. The balance among these forces will determine the strength of demand growth.
26
See for instance, BP Energy Outlook 2016 Edition.

20
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

develop market tools to help influence the price on the upside. Most importantly, there must be the
political will and a change in the mind set to play such a role.
In the absence of such a balancing role, OPEC members would behave in a similar way to non-OPEC
producers, and the adjustment will occur through the impact of prices on the investment cycle.
Decline rates are already high in some OPEC members (see Figure 26) and cuts in investment have
affected the growth potential of countries like Iraq, which continues to revise downwards its long-term
output target. In OPEC, there is the added dimension that low oil prices can magnify the instabilities in
some countries, reducing investment and increasing unplanned outages. (Nigeria and Libya are just
two recent examples where oil production has declined sharply due to attacks on oil facilities and
disputes among warring factions, see Figure 27.) Factors such as deteriorating finances, heavy debt
burden 27 , a crumbling political and institutional landscape raise doubts about the ability of OPEC
producers to entirely push out high-cost producers and whether low-cost reserves would necessarily
be developed first.
Figure 26: Algerian oil output, mb/d

Figure 27: Nigerian Oil Output

Finally, a key element in the lower for longer view is the premise that cost deflation in the industry is
structural and that the efficiency gains experienced in US shale will be transmitted to other segments
of the industry. The evidence, however, is not yet conclusive. A big part of the decline in the cost
structure is due to the lower cost of oilfield services, following the sharp decline in investment.
However, squeezing service providers further is not sustainable in the long term and as the service
industry adjusts by cutting costs and jobs (including R&D on new technologies), its flexibility to
respond to higher demand is being eroded over time. Thus, while some of the recent decline in cost
may turn out to be structural, the bulk is likely to be cyclical and service costs will increase as activity
picks up (and as currencies appreciate). Given the slack in some segments of the service industry
(such as deep offshore drilling) costs may not rise immediately, but this cant be generalized to the
entire supply chain.

The risk of a supply crunch and high oil prices

In contrast, the scenario of a supply crunch and potentially of oil prices rising sooner than expected is
based on a cyclical view of the industry. Specifically, it is based on the following premises:

Demand will continue to grow at its historical trend, in part encouraged by low oil
prices;

Cuts in investment are so deep that they will have a big impact on future
supplies, both inside and outside the USA;

27

For instance, Reuters estimates that Nigeria, Iraq, Venezuela and Kurdistan are due to repay a total of between $30 billion
and $50 billion with oil. With current low oil prices, this would require exports of over 3 mb/d. The diversion of funds to meet
such have debt repayments can cripple long-term investment in the oil sector. See: Reuters, Debt repayments in crude cripple
poorer oil producers, Inside Oil, May 25, 2016.

21
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of the Oxford Institute for Energy Studies or any of its Members.

Geopolitical deterioration and unplanned outages will only intensify these supply
losses;

Due to low investment, decline rates in mature fields will accelerate;

The ability of US shale supply to respond in a higher oil price environment is

constrained and not immediate;

As activity picks up, the cost of oilfield services will increase, reversing some of
the deflationary pressures on the cost curve.

The key dynamic underlying this scenario is that the deep cuts in investment will eventually have a big
impact on supplies both inside and outside the USA. Unplanned outages in oil exporting countries,
together with high decline rates in mature fields, will compound the supply problem. While US shale
supply would respond in a higher oil price environment, the response is likely to be lagged and the
gains would not big enough to offset the decline rates in other parts of the world. However, supply is
only part of the story and for prices to rise sharply, demand should also do its part. According to this
view, the implementation of climate change policies will be slow, so the impact on demand growth will
be limited; despite improvements in efficiency and changes in the energy mix, oil demand would thus
continue to grow at its historical trend, in part encouraged by low oil prices and income effects in
developing countries. Also as activity in the sector picks up, inflationary pressures will start building up
in oil services, shifting up the cost structure for the industry. In short, in the absence of an effective
OPEC balancing mechanism, this scenario predicts that the oil market will continue to be subject to
sharp cycles, and in the event of physical shortages, sharp rises in oil prices will be the only
mechanism to clear the market, especially as spare capacity has reached very low levels. In other
words, even with both the entry of US shale and environmental policies being high in the global
agenda, the shortage in supplies can only be cured by high oil prices.
What could disturb this scenario? One key factor, again, is the response of US shale. US shale
production could stabilize at prices around $50 per barrel and surprise the market again on the upside
if the oil price rises above $60 per barrel. 28 Also, despite the cut in investment, the level of cost
deflation in the industry implies that companies can do more with the amount of capital available,
especially given that many firms have been pursuing measures to enhance efficiency; the impact on
supplies is hence likely to be less than currently thought. Another factor is the environmental agenda
and its impact on both oil demand and the behaviour of producers. In a rising and more volatile oil
price environment, countries will accelerate their environmental policies to curb fossil fuel demand.
This could change the behaviour of low-cost producers, prompting them to invest and to develop their
reserves. Thus, rather than cutting production to support prices, low cost producers have the incentive
to increase their output, driving out high-cost producers, and keeping a cap on the oil price.29

28

For instance in a recent article in the FT, Ed Crooks argues that Oil producers in the US have already ridden to the rescue of
consumers once this decade. Soon they may have a chance to do it again. He concludes his article by arguing that for
consumers, it is a reassuring prospect. Another oil price shock should be averted, unless global supplies are hit by much larger
disruptions than the difficulties they face today. Any countries that need a much higher price to keep their fiscal balances
sustainable, however, will have to think very hard about their future. Fracking will provide a buffer for consumers as oil price
rises, Ed Crooks, Financial Times, 17 May 2016. https://next.ft.com/content/222026b2-1c4a-11e6-b286-cddde55ca122.
29
From an emissions mitigation viewpoint, this scenario is termed the green paradox as owners of hydrocarbon resources
would pre-empt future policies by accelerating the production of fossil energy while they can, inducing higher consumption and
higher emissions, see for instance Sinn, H.-W. (2012), The green paradox: A supply-side approach to global warming.
Cambridge and Mass: MIT Press. However, studies using simulations analysis show that such a strategy would have limited
effectiveness in terms of increasing revenues. See for instance, Loulou, R., Labriet, M., Haurie, A., and Kanudia, A. (2008).
OPEC Oil Pricing Strategies in a Climate Regime, a Two-Level Optimization Approach in an Integrated Assessment, Cahier
du GERAD, G- 2008-71.

22
The contents of this paper are the authors sole responsibility. They do not necessarily represent the views
of the Oxford Institute for Energy Studies or any of its Members.

5. Conclusions
These two scenarios (structural versus cyclical) show the high degree of uncertainty engulfing the oil
market. In reality, we are witnessing elements of both in this cycle. This presupposes that we can
separate neatly the cyclical from the structural, but this would be an over simplification. All the factors
discussed above have become intertwined and the response of one part of the system will affect the
other parts. For instance, the way US shale responds to higher prices will affect the investment cycle
of other non-OPEC producers. The decision of key players, such as Saudi Arabia, to invest in new
capacity will affect long-term expectations and other players incentive to invest. The vigour with which
climate change policies are implemented will impact demand growth and behaviour of key players.
The outcome of the interplay of such factors on prices is far from clear. There was (is) a strong belief
that US shale would act as a stabilizer, moderating price movements both on the upside and the
downside and keeping the price within a narrow range. This view may prove to have been rather
simplistic. The interaction of the various factors shaping the oil market (some of which are short term
while others are long term, some of which are structural while others are cyclical); the diverse nature
of the investment cycle; the potential change in producers behaviour; and the change in the policy
landscape driven by climate change concerns all indicate that the picture is much more complex and
multiple potential scenarios could emerge. Will we end up with milder or sharper price movements?
Will price cycles become shorter or longer? Are there asymmetries along the cycle? Do the structural
changes imply that oil prices will fluctuate around a declining trend or are sharp price rises in the new
oil order still a possibility? All these questions indicate that even if we have a better understanding of
how the various parts of oil supply (OPEC, US shale, non-OPEC) and demand are currently adjusting,
and whether these adjustments are structural or cyclical, it is of limited use in predicting the oil price,
or for that matter the path that the oil price will follow, in the future. But what these questions clearly
show that while the structural and the cyclical views offer some useful insights, neither is able to
characterise the current dynamics and while the oil market will continue to exhibit cyclical patterns,
there is bound to be a change in the nature and characteristics of these cycles.

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of the Oxford Institute for Energy Studies or any of its Members.