John Sfakianakis: U.S. can’t frack its way out of the Middle East

08/09/2013 6:16 PM

08/09/2013 6:16 PM

Reading the newspapers these days, you’d think that the much-hyped impending American energy boom is about to make Saudi Arabia and the rest of OPEC irrelevant. Recent projections by the International Energy Agency, for example, have the United States surpassing Saudi Arabia as the world’s top crude oil producer by 2020, a development that would appear to call into question the kingdom’s role as the world’s strategic energy provider.

But such projections – based, at least in part, on the rapid discovery and development of unconventional hydrocarbon resources in the United States – are far from ironclad. Indeed, they are built around numerous variables that could change over time and hardly foretell the end of Saudi Arabian energy dominance. Just as the “peak oil” debate falsely predicted that worldwide oil production had reached – or very nearly reached – its peak overall production, the shale oil debate is steering public opinion to the opposite extreme.

Even the IEA acknowledges that both future sources of additional crude oil and price remain big unknowns. As the IEA’s chief economist, Fatih Birol, noted in November 2012, “light, tight oil reserves are poorly known. . . . If no new resources are discovered around the world and plus, if the prices are not as high as today, then we may see Saudi Arabia coming back and being the first producer again.” The U.S. Energy Information Administration, meanwhile, predicts that U.S. crude oil production will peak in 2020, placing the United States 47 percent below the IEA’s projections.

Thanks in no small part to new hydraulic fracturing and horizontal drilling technologies, “tight,” unconventional oil trapped in rock and sand beds is becoming more and more accessible. These improved production methods are having a major impact on the U.S. energy supply, contributing to a 43 percent increase in U.S. oil production since 2008.

Many questions remain unanswered about the U.S. unconventional oil story that could have long-term, transformative effects on global oil markets. For example, global demand would have to decline substantially – especially in emerging Asia – in order for U.S. supplies to become omnipotent. The impact of the U.S. unconventional story hasn’t depressed oil prices, which have been fairly resilient to date.

Moreover, the IEA’s expectation that North America will become a net oil exporter by around 2030 depends on how much crude oil is produced not just in the United States but also in Canada and Mexico. Under the IEA’s highly optimistic forecast, the United States might surpass Saudi Arabia in liquids – though not crude oil – production for a brief period. Even then, an increase in self-sufficiency won’t necessarily eliminate America’s need for imports. OPEC’s reaction and member cohesion will have an impact on the way global markets respond to U.S. developments. Technological diffusion can also influence the rate of non-OPEC oil supply.

Demand will ultimately determine America’s appetite for oil and energy at large. In order for the country to become less reliant on imports, demand will have to continue to decline due to efficiency gains. To date, however, there is little indication that this is happening. Middle East oil exports to America, especially from Saudi Arabia, were higher in 2012 than at any time since U.S. tight oil production began its upward trajectory in 2009. Perhaps more important for American consumers, unconventional oil might not necessarily lead to lower prices at the pump. Besides supply and demand dynamics, oil prices are also determined by global geopolitical events.

Yet another reason to be skeptical of the projected impact of unconventional oil in the United States is the sharp decline rate of shale oil fields. More than 80 percent of American tight oil production comes from two sources: the Bakken formation in North Dakota and Montana and the Eagle Ford formation in southern Texas. But decline from a typical Bakken well is steep, with production slumping to one-fifth of its original rate within 24 months. The Eagle Ford wells, meanwhile, could reach the end of their economically useful life within four years. As a result, oil guru and hedge fund manager Andy Hall recently predicted that U.S. shale discoveries will boost production only temporarily and that oil prices will remain high.

Saudi Arabia’s role as the most reliable global oil supplier, meanwhile, is unquestionable. The kingdom has repeatedly helped to stabilize the global oil market and keep prices down by increasing its own production. Currently, Saudi Arabia has a total capacity of 12.5 million barrels per day, and between 2.5 and 3.5 bpd in spare capacity to meet global energy and supply shortage needs. Saudi Arabia accounts for more than 50 percent of global spare production capacity.

In other words, U.S. shale oil is far from displacing Saudi Arabia’s role as the world’s de facto strategic petroleum reserve.

But even if Saudi Arabia is safe atop the global energy food chain, it will need to undertake substantial reforms in the coming years. For the most part, Saudi Arabia has managed its oil wealth sensibly and prudently. Within just two decades, it has seen an impressive improvement in many of its human development indicators. Its dependency ratio – the ratio of working-age people to non-working-age people – has dropped from 79 percent in 1990 to 49.5 percent in 2011, a figure that is below the Organization for Economic Cooperation and Development average. Likewise, between 2003 and 2012, per capita gross domestic product increased 250 percent, while the economy expanded close to 3 1/2 times.

But the future of the kingdom hinges on its ability to curb its domestic appetite for energy. That oil bears the brunt of government and export revenues is undeniable. Encouragingly, however, the contribution of oil to the country’s GDP is falling – from 65 percent in 1973 to less than 30 percent last year. Still, Saudi Arabia will have to cut down on domestic consumption in order to preserve its export capacity. Over the past few years several observers, first and foremost Saudi Aramco CEO Khalid Al-Falih, have alerted the world to Saudi Arabia’s alarmingly high rate of domestic oil consumption.

On an annual per capita basis, Saudi Arabia’s consumption is twice that of the United States and around four times that of Germany, which has an economy that is five times the size of the kingdom’s. Energy use per head is also rising, and between 2000 and 2010, domestic oil consumption jumped by around 30 percent – a considerable opportunity cost for Saudi Arabia. In 2012, 22 percent of total Saudi oil production was consumed domestically, where heavily subsidized fuel encourages energy profligacy.

The situation in the kingdom is worrisome but fixable. The United States faced a similar predicament before 1973, when energy consumption was growing at a rate of more than 3 percent annually. After the oil prices shocks in the 1970s, the economy became more energy-efficient, and energy consumption post-1973 grew at less than 1 percent annually.

Saudi Arabia appears to be taking similar steps to improve efficiency. For example, 2010 saw the establishment of the King Abdullah City for Atomic and Renewable Energy, as well as the involvement of Saudi Aramco and the Saudi Center for Energy Efficiency in efforts to help foster a national debate about reducing costly energy subsidies and directing them to those most in need.

But time is running out for reforms. According to Fitch Ratings, Saudi Arabia’s breakeven oil price, the price at which oil revenues cover the cost of expenditures, has spiked from just more than $40 per barrel in 2008 to $76 per barrel in 2012. And if public spending continues to rise at the present clip, the breakeven price will soar to unsustainable levels.

Some analysts have gone as far as forecasting a possible oil shock on the order of the 1986 glut, when prices dropped from $27 per barrel to less than $10 per barrel. But the likelihood of oil prices dipping to $50 a barrel in the coming years is low because the era of cheap oil is most likely over. Much will turn on demand, which is set to grow to between 100 million and 112 million bpd by 2035, from just more than 89 million today, according to the IEA and the EIA, respectively.

The marginal cost of oil for the 50 largest oil and gas producers globally, meanwhile, has been increasing by 11 percent year on year – in line with historical trends. Currently, the marginal cost hovers around $100 per barrel.

The claim that prices will be pushed down by alternatives to oil in the transportation sector – such as compressed natural gas, methanol and electricity – might be true, though these alternatives have been around for a long time and they all have their drawbacks. However, Saudi Arabia’s oil policy objective is not high prices at any cost in order to fund its fiscal obligations. Fiscal discipline can be applied when necessary without imperiling the country’s development needs.

The U.S. energy boom is positive and transformative for all, but unlikely to power a shift from a global energy scarcity to a paradigm of plenty.

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