Blog | Commodities

The American Energy Revolution

Oil production in the United States is exploding as the result of horizontal drilling and fracking. The country is on track to be energy independent by 2020. The profound economic and geopolitical implications of this energy revolution will be the topic of this week’s blog.

Crude oil production in the US fell from 9 million barrels per day in the mid1980s to 5 million barrels per day in 2008. It now appears that production could return to 9 million barrels per day by 2016 or 2017. Horizontal drilling is responsible for the production surge. Until recently, oil companies drilled straight down, hoping to find a pool of oil reserves. Now, new technologies allow them to drill down and then out horizontally. This breakthrough, combined with the high-pressure injection of water and chemicals into the wells, now permits the extraction of oil from rock formations that was hitherto impossible – or at least unprofitable. The resulting surge in production has obliterated previous assumptions about production potential in the US and around the world. The “Peak Oil” theory has once again been discredited, as it has been many times before.

Meanwhile, the demand for oil in the US and globally is much weaker than had been anticipated. The global economic crisis caused demand to be much less than forecast. Energy efficiency has also increased rapidly. New cars in the United States are now averaging 34 miles per gallon, up from 28 miles per gallon twelve years ago. More generally, oil consumption per unit of GDP in developed countries has fallen sharply and steadily for decades. Finally, renewable energy sources such as solar and wind have also begun to come on stream and are lowering the demand for oil.

This combination of increased supply and weak demand has meant that oil imports into the US will have fallen by more than 40% by the end of this year compared with 2007 – from approximately 13.8 million barrels per day to approximately 6.8 million barrels per day in 2013. Even more astonishingly, present trends suggest the United States may cease to import any oil at all by 2020 or soon thereafter.

At first glance, this incredible and unexpected change in the supply and demand for oil would suggest that oil prices should plunge – and indeed they may. However, don’t forget that oil prices are not freely set by the forces of supply and demand. They are determined by a cartel that strives to keep the price high by limiting the supply. There are nearly limitless pools of oil under the Arabian Desert. Saudi Arabia and other OPEC members set the price of oil by restricting the amount of oil they bring to the surface. Therefore, there is a strong likelihood that Saudi Arabia will soon begin to cut back on its production to keep prices high. It is not certain, however, if that country can afford a very significant reduction in oil revenues that would follow a cutback in production. The Saudi government responded to the Arab Spring revolutions in Egypt, Libya, and Tunisia by giving even greater government subsidies to the Saudi people to ensure their tranquility. A sharp cutback in oil production would put a strain on the kingdom’s finances and possibly threaten social stability.

Elsewhere in that region, sanctions on Iran have reduced that country’s oil output. On the other hand, Iraq, which is believed to have the second largest supply of oil reserves in the world after Saudi Arabia, is aggressively expanding its oil production. Its output should more than compensate for the Iranian oil taken off the market as this decade proceeds.

Barring a new war in the Middle East, it seems reasonable to expect that oil prices will decline during the years ahead. Either way, the trend toward self-sufficiency in oil will reduce the United States’ reliance on Saudi Arabian oil. This change could bring about a diplomatic realignment in that region as the Saudis are forced to turn to China to buy the oil that the United States will soon no longer require. If so, China’s influence in the Middle East would increase substantially. The consequences of such a scenario are uncertain, but potentially extremely significant.

US self-sufficiency in oil, if realized, will also have very significant implications for the US current account deficit, which, in turn, could meaningfully impact the value of the dollar and US interest rates. Last year, US net imports of oil amounted to approximately $330 billion, whereas the overall US current account deficit was approximately $450 billion. Therefore, oil self-sufficiency has the potential to reduce the US current account deficit by roughly 75% from its current level.

A sharp reduction in the current account deficit should cause the dollar to appreciate. A higher dollar would have a negative impact on US exports and would likely cause more (non-oil) imports to enter the country. In this scenario, the oil exporting countries would suffer from less US demand, but the Unites States non-oil exporting trading partners would tend to benefit from greater US demand.

The impact on US interest rates would depend to a great extent on whether oil prices fell sharply or remained stable around current levels. A sharp fall in oil prices would cause disinflation - or even deflation - which would keep interest rates low. On the other hand, if oil prices remain high, interest rates could rise. That is because the reduction in the US current account deficit would cause a similar reduction in the US capital account surplus. (Every country’s balance of payments must balance, so the larger the current account deficit, the higher the capital account surplus.) In other words, the oil exporting nations would accumulate fewer dollars and, therefore, would buy fewer US government bonds than they do now. That could result in falling bond prices and higher yields (i.e. interest rates).

As all of the preceding discussion suggests, there are a lot of moving parts in this story that impact one another in various ways. Therefore, the ultimate consequences of this revolution in US oil production are difficult to predict with any degree of accuracy. Overall, however, this must be a net positive for the United States and a significant net negative for the world’s oil exporting nations, and that includes not only the OPEC countries but Canada as well.

The possibility that the United States will become energy independent is a new development and potentially a game changer in many respects. This is a theme that no investor can afford to ignore. It is a subject I intend to consider carefully during the months ahead.