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What's ahead for global energy markets? How will the U.S. shale revolution affect our energy future? To find out, we asked Stephen Arbogast, an expert with more than thirty years of experience in finance working with the energy sector. As Prof. Arbogast explains, when it comes to global energy markets, the next decade will look very different from the last four decades. 

Stephen Arbogast is an Executive Professor of Finance at the C.T. Bauer College of Business, University of Houston. In that capacity, he has authored more than 70 case studies on technical and economic aspects of the energy business. He is also the author of the book Resisting Corporate Corruption, now in its second edition. Prof. Arbogast has taught in graduate MBA programs since 1987 and was awarded the Bauer College Payne Teaching Excellence Award in 2008.

We thank Prof. Arbogast for taking the time to answer our questions. For more PERC Q&As, visit the series archive.

Q: You’ve said that when it comes to the geopolitics of energy, the next decade could look quite different than the last four decades. What do you mean by that?

A: The last four decades have been dominated by the operations of the OPEC cartel. With only occasional exceptions, this cartel has determined the general price level for crude oil. This price represents roughly two-thirds of the price of final products to consumers, so it is most consequential for the cost of energy in developed economies. The next decade could be different for two reasons. The first is the shale revolution. Right now, that revolution—unlocking oil and gas from tight rock formations—is catapulting the U.S. back to a position of world’s leading oil producer. What is not known is the extent to which this will spread to other lands. Many non-OPEC countries, including China, have vast shale resources. To the extent production surges outside of OPEC, the cartel’s dominance will certainly decline.

The second issue is more ominous and concerns a key OPEC member, Saudi Arabia. For decades the Saudis have operated as OPEC’s flywheel, absorbing production cuts in times of glut and expanding production to combat scarcity. Will Saudi Arabia remain much as it has been in the years ahead? Will it still be ruled by the extensive Royal House of Saud? One looks at Syria, Egypt, Iraq, Libya, and Iran and wonders.

Q: How has OPEC shaped oil politics in the past, and where are we headed?

A: In 1973, OPEC discovered it could dictate the short-term price of crude oil. The cartel saw that developed nation oil demand is quite inelastic over the near term. This means the cartel could and did dictate price to its customers. The result then was a 400% price increase that brought to the OECD nations. Over time, the cartel also learned that abrupt price hikes sow seeds of reversion. Price hikes to $40/b in 1980 led to a demand bust and price collapse below $10/b in 1986.

These experiences led OPEC, under Saudi leadership, to a price targeting strategy. The cartel seeks prices which balance several objectives. First, they must be high enough to generate current revenue to fund the political models in these states. These political models concentrate wealth in the state and purchase political support with generous handouts and subsidies. Second, the prices should not be so high that they trigger demand destruction undermining the price level’s foundation. Finally, they also should not encourage sustained efforts to replace petroleum with alternative fuels.

Surveying the history of price levels since 1973, it must be conceded that OPEC largely achieved these objectives. No alternative fuels “silver bullet” has emerged. Demand for petroleum has grown and most forecasts show it growing for decades to come. Only the shale revolution and regional political stability raise the possibility of shaking the cartel’s grip on the energy price.

Q: What role does Saudi Arabia play?

A: Saudi Arabia plays the role of “swing producer” within the cartel. This means the Saudi’s reduce production in times of glut and increase it during moments of peak demand. Cartels generally require some member willing to play this role—otherwise supply and demand excesses will drive prices to cyclical peaks and troughs.

The Saudis have unique characteristics that, alone among OPEC members, allow them to play this role. First, they possess huge oil reserves, estimated to exceed 200 billion barrels. This allows the Saudis to add production capability and maintain the spare capacity needed to cushion demand peaks. Second, the Saudi have a small population. Until recently that population did not exceed 20 million. This meant that the Kingdom could amass large financial reserves during periods of peak demand and prices. These reserves could then be drawn upon to fund domestic spending when slack demand required the Kingdom to cut production.

It is not as clear going forward that the Saudis will be able to play this same role. Despite their ample reserves, the Saudis seem to be having difficulty increasing production capacity beyond 12 million barrels per day. Much of their “spare” is less desirable medium and heavy crude that encounters refining bottlenecks during demand peaks. Meanwhile, a larger, more subsidized population has raised the cost of preserving social peace. Indeed, one can detect elements of domestic concern in the current Saudi hard line towards Syria and Iran.

All this said, the graveyards are full of people who prematurely forecast the demise of the House of Saud. The shale revolution, ironically, could pose more of a threat than disturbances among their neighbors if it undermines the crude price and pinches the Saudi paternalistic ruling model. 

Q: We’ve seen a number of sharp peaks and troughs in oil prices over the last few decades. How much of a role does OPEC play in driving or moderating these changes?

A: The answer here is a bit unconventional. OPEC has usually been divided into price hawks and a more moderate, long-term optimizing group. Before 1980, Iran and Libya led the hawkish group. During this period, they repeatedly succeeded in driving prices to peaks well beyond those envisioned by the more moderate, Saudi-led group. Between 1980 and 1985, a major showdown took place between the two factions. This climaxed with the Saudis flooding the market with production, leading to the price bust of 1986. Since then, Saudi price policy has largely reined. The cartel has effectively managed prices when its spare capacity lies within 3-6 mb/d. Since 1986, price booms and busts have largely resulted from demand “surprises” that moved cartel spare outside of this range. The Asian crisis of 1997 produced a demand bust that toppled crude prices in 1998-99. China’s stupendous demand growth then fueled a demand peak that led to record prices in 2008. The Saudis have tried to reinforce their capacity to manage demand by adding new production capacity. There are, however, widespread doubts as to whether the Saudis can expand beyond the present 12 mb/d level.

Q: What influence does OPEC’s price umbrella have on oil development throughout the world? What are its implications for North American energy development?

A: Somewhat perversely, it means that higher cost oil gets developed first. Much OPEC oil is very low cost. In particular, the reserves in Saudi Arabia, Iran, Iraq and Libya are easy to develop – largely onshore drilling of already discovered fields. Political constraints of various sorts, including war and civil unrest, combine with OPEC policy to prevent their development. Meanwhile, the international oil industry busies itself developing much higher cost oil in politically safer locations – tar sands in Canada and “pre-Salt” finds in deep water Gulf of Mexico. A single well in this later location can cost well over $100 million to drill. The average cost of production for tar sands, including a return on capital, is probably in the $65/b range

The implications for North America are interesting. The OPEC price umbrella has ultimately paved the way for North America to become self-sufficient. Both the Canadian tar sands and the shale oil production are economic at $80/b and higher. Assuming current price levels remain in place, North America’s economies should need no crude oil imports by 2020.

Q: What about unconventional energy sources? How do global markets affect these energy sources?

A: Global prices determine whether these resources can be economically developed.  The answer today for tar sands and shale oil is yes.

Logistics enter the picture at this point. One fascinating, recurring story in the energy business is that new oil and gas keeps showing up in unexpected places. Then it becomes imperative to put logistics in place to get the new production to market. Nobody expected new oil and gas production in places like Pennsylvania and Ohio. Similarly, little infrastructure existed in the Bakken and Eagle Ford basins; much of that in the Permian basin of West Texas was old or ran in the wrong direction. Pipelines adequate for new Canadian tar sands production don’t exist. These logistical bottlenecks suppress production for a time and depress current prices. This is the reason why West Texas Intermediate, the main U.S. benchmark crude, has carried a $5-15/b discount versus international prices for the past several years. Over time these logistical bottlenecks will be removed and the price discrepancies will disappear.

However, these kinds of infrastructure constraints will be big issues for other countries with shale oil and gas reserves. Here we are talking about countries as diverse as China and the Ukraine. There is vast potential elsewhere in terms of what’s geologically under the earth. In terms of infrastructure, however, these lands are way behind where the U.S. was as the shale revolution began. Together with other limitations, their inadequate infrastructures will delay the shale revolution from spreading globally.

Last we must say a word about shale gas. It is different from oil in that it is much harder to transport internationally. Liquefying the gas into LNG is the principal means, but this requires huge capital, massive facilities, and special ships. Those only get built when there are firm buyers and long-term contracts. Without these, new gas can be “stranded”—discovered but left in the ground. That is the story today with much U.S. shale gas. It needs export permits to find overseas LNG markets, but the Obama administration has been “slow walking” these approvals for various reasons. 

Shale gas developed overseas, say in China and the Ukraine, should find immediate uses in power, heating, and manufacturing. These countries are energy importers and use copious quantities of coal that can be replaced.

Q: What are the environmental implications of foreign vs. domestic energy production?

A: This is a tricky business. Domestic U.S. energy production increases the environmental impacts within the physical U.S. However, these efforts are intensively regulated. Even allowing for a major failure like the Deepwater Horizon, from a global perspective, energy operations in the U.S. will be safer and more environmentally sound than in many other energy producing locations. Globally, it’s better to have more production in the U.S. and less in China, Nigeria, or Angola. But, that will not satisfy the NIMBY crowds within our ranks.

Q: What impact will the U.S. shale revolution have on global energy markets and on the U.S. economy?

A: The shale revolution is an enormous breakthrough, but it needs to be carefully understood.  Let me outline three key points.

First, we are at the beginning of understanding this revolution. There is much we do not know. We don’t know how much “source rock” can be exploited worldwide in this way. In other words, we can’t yet estimate the total amount of additional oil and gas reserves now available through fracking and horizontal drilling. In addition, we don’t yet have a finished exploitation technology. Service companies and producers continue improving their methods. For example, some companies are fracking in the Eagle Ford without using water. All of these improvements mean that we don’t yet know the lowest production costs feasible for shale production. Obviously, the lower these costs and more flexible the methods, the more reserves can be exploited worldwide.

The second point is that the shale revolution poses major policy challenges for many countries.  The U.S. is in many ways “lucky” in that it has unique conditions conducive to shale development. In the U.S., private landowners own the mineral rights on their land. They can lease these to developers without having to get an approval from Washington. Also, regulatory activity is largely at the state level. The U.S. is fortunate to have a collection of states friendly to oil and gas production. Texas, Oklahoma, Louisiana, and Arkansas all gave immediate blessings to shale development. One only needs to look at Pennsylvania and New York to seek how different attitudes on this can be. The former is merrily supporting development and harvesting huge economic and fiscal benefits. The latter is happily preserving the quiet economic destitution of the western part of the state. It’s about these kinds of choices, but in the U.S. with its federal system, we are blessed with the opportunity to have different choices made in different places. Other countries are not so fortunate. Whether you are talking about China or the U.K., the central government controls the mineral rights. Local communities see no benefit from the inconveniences of development, and so are largely united in opposition. How these governments will change their current arrangements to share benefits with the local communities is a policy issue. Most of these policy choices have yet to be made.

Collectively these points mean that the U.S. is soaring ahead of everywhere else in shale development. This is bringing fantastic benefits to the U.S. economy, in no small part because the slowness of response elsewhere means the U.S. can go full-bore ahead without collapsing the price structure. If everybody was climbing aboard the shale revolution, prices would probably crater – dropping below that needed to support new drilling. If everyone started drilling for shale oil right away, we’d probably see $60/b oil that would stay there for some time. 

Because this is not happening, U.S. shale development can proceed to deliver both good returns to developers and stable prices to consumers – indeed some of the recent price moderation drivers are seeing at the pump is due to the bounty of light crude coming out of U.S. shale production. The benefits hardly stop there. State treasuries are being replenished. The federal government is drawing increasing revenue and royalties from production on federal lands. Cheap gas has reinvigorated energy-intensive manufacturing in the U.S. The number of new chemical plants announced and under construction is staggering. Our balance of payments benefits greatly. Oil imports are down sharply while exports of refined products, chemicals, and natural gas grow rapidly. Abundant natural gas is displacing environmentally dirty coal in power generation. Lastly, we have gained more protection and freedom of action in the national security arena. Physically our economy will not be touched by embargoes or outages in the Middle East, though prices will still be impacted. Plentiful gas gives us diversification options to cut exposure to global oil events further.

This brings us to the last point. We need to think of this revolution as a reprieve, not a permanent reversal. However abundant the shale reserves, they are still finite and subject to depletion. This means the search for other, renewable sources of energy must continue. When oil prices busted in the 1980s, much research into alternative fuels was abandoned. When efforts resumed around 2006, the research experts were long gone. This boom and bust cycle in energy research should not be repeated. Building subsidized industries that cannot compete under current prices is not desirable, but continuing to prepare for tighter supplies and higher prices down the road should be a good national investment.

Bjørn Lomborg draws upon the work of Bruce Yandle of PERC to warn against climate solutions touted by emerging green activist/big business alliances:

This sort of reaction—activists and big energy companies uniting to applaud anything that suggests a need for increased subsidies to alternative energy—has been famously described as the so-called "bootleggers and Baptists" theory of politics. The phrase comes from the South, where many jurisdictions required stores to close on Sunday, thus preventing the sale of alcohol. The regulation was supported by religious groups for moral reasons and by bootleggers for market reasons. Politicians would adopt the Baptists' pious rhetoric, while quietly taking campaign contributions from the bootleggers.

The climate-change "Baptists" provide the moral cover that politicians can use to sell regulation, along with scary stories that the media can use to attract readers or viewers. Businesses see opportunities for taxpayer-funded subsidies, and to pass on inevitable cost growth to consumers. Unfortunately, this convergence of interests can push us to focus on ineffective, expensive responses to climate change. Whenever opposite political forces attract, as activists and big business have in the case of global warming, there is a high risk that the public interest will be caught in the middle.

If we want to help the world's poor avoid the pain of higher food prices, we should focus on developing better and more nutritional crop varieties, getting more fertilizer to farmers, fighting for freer trade, and, of course, the elimination of biofuel support. Those are the policies that would make a real impact on food prices.