A consensus has developed that Saudi Arabia has surrendered its role as de facto manager of the world oil market to U.S. shale oil producers. The so-called swing supplier position that the Saudis long held brought with it great geostrategic influence. But it is misleading to suggest that the United States will now wield such power.

U.S. shale production is nimble when compared to other sources of oil, and it will inevitably oscillate up and down to address imbalances in supply and demand. However, the U.S. shale industry is made up of individual producers who are each price takers, not price makers. As such, they cannot serve as true swing suppliers, which balance monopolistic and oligopolistic markets. Instead, they are marginal producers, balancing a competitive market. The distinction between the two is often misunderstood in discussions of the shale oil boom—and it is ultimately a reminder of the limits of U.S. power, even in the age of abundance brought by the plentiful supply of new unconventional oils.

David Livingston
Livingston was an associate fellow in Carnegie’s Energy and Climate Program, where his research focuses on emerging markets, technologies, and risks.
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Nevertheless, shale has introduced new competition into the oil market, on the whole benefiting consumers and producers alike. Rather than seeking to leverage the age of abundance as a geopolitical tool, U.S. policymakers should seek to sustain, and even enhance, this newfound competition in the oil market. In doing so, they will help to unlock a new age of competition that will yield economic, social, and even environmental dividends for years to come.

The Lone Star

At the outset of the 1930s, abundant, easy-to-extract oil in East Texas fields attracted a contingent of small, independent well owners—somewhat reminiscent of today’s shale producers—who began competing with established oil majors. Lacking insights into global oil demand and an effective coordination mechanism, each small producer acted in its own perceived self-interest to maximize production. In 1931, the global market was pushed into dramatic oversupply and prices dropped to as low as $0.10 per barrel.

When the powerful Texas Railroad Commission, acting on behalf of the big oil companies, issued so-called prorationing orders to limit production, independent producers initially flaunted the limits—until the governor of Texas brought in the National Guard to enforce the orders. The curbs on production created new, flexible spare capacity in the Texas oil patch—a buffer that made it possible to boost production in the space of days. The United States accounted for more than half of world production until 1953, with the Texas Railroad Commission acting as a de facto monopolistic player in the global oil market, largely serving the interests of the oil majors.

In theory, oil producers can cut production and significantly impact prices if one actor has disproportionate market share. This can take the shape of a monopoly, with a single dominant player like Texas, or an oligopoly, where a few large players dominate total production but need to collude in order to affect prices. Yet while a textbook monopoly restricts production in order to maximize profit, the Texas Railroad Commission regulated producers primarily to balance markets, thereby defining the role of a canonical swing supplier.

The Texas Railroad Commission balanced markets by ramping up and down production. For example, it cut production to address the oversupply that had developed in 1931, and, in June 1967, it blunted the effects of the first Arab oil embargo by bringing new production online from its sizeable spare capacity.

The Texas Railroad Commission persisted as a swing supplier from the 1930s until the 1970s, despite the United States losing market share as many new oil discoveries in massive, low-cost fields throughout the Middle East and Latin America were brought online.

However, Texas’s status as swing supplier could not last in perpetuity. The state gradually pushed production to full capacity as U.S. oil demand accelerated in the late 1960s and early 1970s, using most of its spare capacity to balance the market. As the Organization of the Petroleum Exporting Countries (OPEC) overtook Texas in terms of market share, the state’s remaining spare capacity was eliminated, leaving it unable to boost production to enforce a price ceiling. When the Yom Kippur War led to another Arab embargo in 1973, the shock-absorbing spare capacity of Texas was exhausted. Prices soared. One era had ended, and another began.

The Last Swing Supplier

Just as Texas did not behave as a textbook monopoly, there is little evidence that OPEC has behaved as a textbook oligopolistic cartel. Instead, as a whole OPEC has seemed to prioritize market stability over higher short-term profits.

Oil producers with the reserves to produce for many decades to come have always idealized balanced markets: a stable price somewhere between the Sisyphean highs and lows that could destroy future global demand (and hurt future profits) or reduce incentives for future investment (and cut into current profits) respectively.

Saudi Arabia has led OPEC’s market-balancing function by retaining significant spare capacity to address global price spikes. From 2003 until the 2008 financial crisis, as prices increased near exponentially, the kingdom produced greater volumes, reducing its spare capacity. A similar boost in production from spare capacity came when the Libyan crisis took around 1.4 million barrels per day (mbd) off the market in early 2011 and again in 2013.

The exact impact of Saudi spare capacity on markets is difficult to quantify. However, the presence of such a player, ready to quickly increase supply in meaningful volumes in order to stabilize the market, provides a physical and psychological backstop for rising oil prices. Indeed, the quantity of spare capacity held in reserve is an indicator of Saudi ability, or willingness, to suppress prices during a price upswing.

In contrast, Saudi Arabia’s ability to control falling prices and enforce a durable price floor is limited by the actions of other actors, both within OPEC and outside of it.

While Texas in 1960 kept more than 15 percent of world production as spare capacity, Saudi Arabia’s entire market share today is less than that, leaving it with little power to cut production and boost prices alone.1 In the 1980s, the Saudis unilaterally cut production but failed to have a substantial effect on price, as other members of OPEC quickly responded with increased production to capture the market share that Saudi Arabia had effectively vacated. When Saudi efforts to lift prices failed, the kingdom aggressively expanded output, tapping much of its spare capacity, and pushed prices yet lower, punishing other OPEC members for exceeding their quotas.

Other producers have a natural incentive to boost supplies if prices are higher than their break-even costs to take advantage of the price differential. So the most important indicator of Saudi Arabia’s ability to place a floor on prices may be the cumulative market share of the countries that it can bring with it to cut production, weighed against the ability of other suppliers to increase production in response to such an action.

Moscow ended up reducing its exports somewhat, but this was mostly due to a freezing winter that temporarily stunted some production. In December 2008, as the world was tipping into recession and oil prices were collapsing, OPEC again applied pressure on Russia to coordinate a production cut with the cartel. Russia’s energy minister at the time promised a 1 percent cut in 2009, but Russia later reneged on this commitment and instead lifted its production by 1.5 percent over the course of the year.

Since the early 1990s, Saudi Arabia’s market share has declined even though its crude production has steadily risen. This declining market share, as well as the growing number of actors capable of putting significant additional production in the market in response to a Saudi cut in production, helps explain the country’s decreasing ability to construct a price floor. Moreover, OPEC did away with individual production quotas in 2008, making it less capable of identifying and holding accountable those who contribute to overproduction beyond the aggregate quota—an element of today’s market that threatens the cohesion of OPEC.

Similarly, Saudi Arabia’s ability to enforce a price ceiling may also soon be limited by a continued reduction in its spare capacity, driven by domestic growth in crude oil and refined product consumption, combined with a need to retain market share and export proceeds.

With Saudi spare capacity at its lowest point in decades—except for periods when it has been used to inject supply into the market—increased volatility in oil markets should be expected. However, many market observers believe that shale oil can act as a balancing force to counteract this instability. It seems to provide Saudi Arabia with the stability it desires while simultaneously sparing it the responsibility of frequently adjusting production in pursuit of relative market equilibrium. The extent to which shale can balance the market is, in effect, the extent to which Saudi Arabia can afford to reduce its spare capacity and concurrently achieve the goals of both market stability and sufficient revenue to sustain bloated budgets.

Shale on the Margin

Critically, there are two types of market balancers—swing suppliers and marginal producers.

Swing suppliers use spare capacity to boost production in crises or coordinate production cuts in times of oversupply, moves they can only make in an oligopolistic or a monopolistic market structure.

Marginal producers balance the market by supplying until they no longer make a profit. When prices are lower than break-even costs, marginal producers stop production and shut down. Marginal producers have no premeditated intention of balancing the global market; instead they simply follow price signals. Their fate is intrinsically tied to the oil price.

Determining whether Riyadh has handed at least some of the power—and burden—of balancing the oil market to U.S. shale producers hinges upon a thorough understanding of shale’s unique characteristics.

Shale oil is drawn from an array of geologies, leading to a range of average break-even costs among different plays that fall between approximately $40 and $80 per barrel. While it is tempting to average the break-even range out to a single number, shale’s varying physical characteristics result in sweet spots and unproductive spots within the same play and an even larger range of costs than these averages suggest.

Shale acts as a market balancer because as oil prices drop below shale wells’ break-even costs, production should slow, and as oil prices go above break-even costs, production should increase. Following the sharp decline of oil prices—from a high of nearly $108 in June 2014 to a low of $44 in January 2015—shale production levels posted their first fall in April 2015. Because shale wells take less time to drill and complete than comparatively larger conventional oil projects, which require years and many millions of dollars to move from planning into first production, shale production should increase more quickly than conventional production when prices rise.

Moreover, the U.S. shale sector’s reliance on credit also makes it more vulnerable to the whims of investors, and thus, to short-term price fluctuations, than conventional oil projects. The Bank for International Settlements estimates that the debt burden of the global oil and gas sector has more than doubled since 2006 to approximately $2.5 trillion at the end of 2014, with $1.4 trillion in bonds and the remainder in loans. The vast majority of the increase is attributed to the borrowing activity of U.S. independent shale firms, far outpacing their contribution to overall production.

Shale producers’ ability to respond quickly to price changes and their dependence on relatively volatile sources of credit make them prime examples of marginal producers.

And, whereas swing suppliers like Saudi Arabia and the Texas Railroad Commission before it adjust production by choice, marginal shale producers adjust production out of necessity. The United States has not gained any power by becoming the market balancer. Rather, it has solely taken on the burden of doing so.

The True Power of Shale

Shale’s real contribution has been to move the global oil market down the ladder of monopoly and up the ladder of competition.

A market tends to better support monopolistic or oligopolistic structures when it has high barriers to entry and/or increasing returns to scale, because high barriers to entry mean only a few producers can justify the costs necessary to compete, and increasing returns to scale allow those players to consolidate their positions.

And indeed, the barriers to entry are high in today’s conventional oil sector: large pools of conventional oil are no longer easy to reach, but instead are found mostly in deep ocean waters or politically unstable regions, making projects expensive to complete.

In contrast, shale represents a supply source with much lower barriers to entry. It only takes $4–$10 million to fund the drilling and completion of a single shale well, compared to the hundreds of millions needed to drill conventional wells, and shale companies have had easy access to credit amid historically low interest rates.

Low barriers to entry have contributed to the existence of hundreds of small, independent shale oil producers. And shale firms have taken advantage of a well-defined mineral rights regime in the United States that ensures rights to subsurface shale oil are clearly allocated and secure.

Shale also demonstrates lower returns to scale when compared to the rest of the global oil market. Only small, highly risk-tolerant firms well-suited to the uncertain nature of shale drilling have thus far demonstrated success in the sector. The fortunes of shale producers depend primarily on the highly variable quality of the rock formations they own, rather than on the accumulated project management expertise in dealing with the technical, political, and financial complexities of large, multiyear projects that is so important to the oil majors.

Taken together, four factors that characterize the U.S. shale industry—reduced barriers to entry, lower returns to scale, well-defined property rights, and a large number of firms— point toward the Platonic ideal of perfect competition. While such perfect competition remains elusive, the arrival of shale on the global oil market seems to have engendered some benefits of competition, including lower prices, widespread increases in productive efficiency, and a reduction in the market power and the price-setting ability of any single actor—all of which stand to benefit the market more broadly.

Sustaining and Improving Oil Market Competition

U.S. policymakers may be tempted to act as if they possess a powerful new tool to control world oil markets. Some market observers argue that creating a shared intention among shale producers to control prices—by encouraging them to work together and become the new swing supplier—would ensure U.S. dominance of global energy markets. However, such collusion would be antithetical to the competition that shale has injected into markets, would eradicate the benefits competition provides to consumers and producers alike, and, in any case, is likely impossible due to the competitive nature of the U.S. market.

Rather than seeking to leverage this age of abundance as a geopolitical tool in the way that past swing suppliers have wielded their power over the market, the U.S. policy community should embrace and build upon the important new strategic context that shale brings to the global oil market.

Shale has decreased the potential for energy to be used as a geopolitical or economic weapon by any actor. This new age of competition can yield greater long-term value for the worldthan any individual swing supplier can bring to its own country. It may be for this reason that Saudi oil minister Ali al-Naimi has maintained that the new unconventional shale oil supply “is a welcome development” for global markets.

While recognizing this triumph of competition is important, it should not be celebrated prematurely because it may not last. The shale industry could be out of business in only a few months’ time if the U.S. oil patch dries up, taking financing with it, or if environmental damages become so severe that shale drilling is banned. These constraints should not be denied or ignored. They are real, but they can be managed responsibly by policymakers.

The key for U.S. policymakers in managing the oil market is thus to encourage and broaden competition in the energy sector globally, while understanding that shale’s power may not last forever. There are a few specific areas in which both foreign and domestic policy makers can work together to ensure that competition is sustained and enhanced, bringing benefits for consumers and producers globally for years to come.

First, transparency on oil reserves, supply, demand, quality, and other key oil characteristics both domestically and internationally can improve competition and should be encouraged. The benefits are numerous and contribute to competition in different ways. For example, in the shale sector, producers may be able to pinpoint and acquire more promising acreage from more detailed or publicly accessible geological data, further decreasing barriers to entry and minimizing unnecessary environmental impacts. Mandatory disclosure of chemical analyses of oil, known as assays, would decrease transaction costs by allowing refineries to blend more effectively—this is especially important for those refineries seeking to refine shale and other new, unconventional oils for the first time. More data on oil movements would prevent bottlenecks in the market. And, with more transparency on where oil companies get their fuels, consumers would be better able to make choices. And so on.

Second, policymakers should address shale’s significant local environment impacts and climate impacts, as well as the safety considerations it brings, which all threaten the sustainability of the sector. Local environmental impacts in effect force U.S. communities to pay for the global market benefits of shale. Domestic policy makers should ensure that shale’s global benefits are accompanied by first-in-class safeguards for the U.S. environment and public health. Shale’s seismic and groundwater impacts are of particular concern, and greater transparency and research in these areas are also essential.

Without proactive management of these issues, and a thoughtful, effective regulatory architecture that internalizes social and environmental costs, unprepared state regulators can easily be caught off guard. When unexpected events occur—such as the flurry of seismic activity in Oklahoma in June 2015—there is a danger that production may be blocked reflexively. Oils will and should compete in the market against one another, and against alternative energy sources, based on a holistic assessment of their full costs, not just production costs.

Finally, U.S. foreign policy can be used to encourage competition in the global oil market more broadly. Policymakers can intensify efforts to discourage subsidies to consumers and producers abroad, taking advantage of low oil prices, which can ease the fiscal burdens that governments face. The United States should also continue to ensure maritime security so that oil shipping lanes are kept open and free from interference by both nonstate actors and Iran, which has on a number of occasions seized vessels and raised tensions in the Strait of Hormuz. And it should continue to encourage stability in oil-producing regions by promoting good governance.

Encouraging and broadening competition will take time. It will also require the participation of industry, civil society, and global leaders, and it will undoubtedly encounter numerous obstacles. Better policies can increase the competitive nature of the oil market as a whole, building upon the changes that shale has already brought to the physical market. However, with humility and a long-term perspective, the United States can leverage its consuming and producing power to promote a number of principles that would have positive, durable, and widely shared benefits for years to come.

Eugene Tan is a junior fellow in Carnegie’s Energy and Climate Program.


1 According to data from John Kemp at Reuters, Texas held 3.4 mbd as spare capacity in 1960. World production was 22.4 mbd in 1960, putting Texas’s spare capacity at 15.2 percent of world production that year. In 2014, the Saudi market share of total oil supply was 12.5 percent.