When Saudi Arabia led an OPEC decision to end a restraint put on oil production in November 2014, it marked the beginning of a new era in oil economics. It has given us a tumbling oil price, prompted huge losses and job cuts at oil firms like BP and might yet give us economic and political drama in the heart of Moscow. To understand why, it’s worth drilling down to the start of the whole process, and the costs of getting oil out of the ground in the first place.
Historically, the OPEC cartel of oil-producing nations has been able to manage oil prices because of the lack of flexibility in global supply. The whole business of setting up wells, operating pipelines and building rigs entails large and long-term investments which makes producers slow to respond to price movements. And a small cut in OPEC supply can have a significant impact on the global oil price.
The advent of the US shale oil boom changed this dynamic. The industry has lower fixed costs but higher variable costs and is more like an industrial process than a major one-off investment. That makes it more responsive to price movements and more flexible in adjusting short-term output.
Overall though, shale is a relatively high cost source of oil, especially compared to Middle East production. As a result, when US shale threatened OPEC’s market share, the cartel allowed a position of global oversupply to develop. It was a simple trick: make oil prices fall to make shale unprofitable.