Oil exporters’ responses to the US fracking boom

In a nutshell

In the absence of the US fracking boom, the global price of crude oil since 2011 would have been considerably higher.

This effect pales in comparison with the decline in the oil price that took place after June 2014, to which shale oil contributed little.

Given the likelihood of persistent low oil prices, fiscal retrenchment looks essential for Arab oil-exporting countries.

It is common to attribute most of the decline in the oil price since June 2014 to increased US production of shale oil – the so-called ‘fracking boom’. But analysis by Christiane Baumeister and Lutz Kilian shows that higher oil production elsewhere in the world, a global economic slowdown, and shifts in oil price expectations and storage demand have all contributed to the decline.

In a related study, Lutz Kilian measures how much global oil production would have been lower if the fracking boom had never taken place. Figure 1 shows both the observed path of global oil production and where oil production would have been without US shale oil. The analysis determines what sequence of oil supply shocks would have been required to force global oil production to follow this counterfactual trajectory.

The model implies that under this counterfactual, the Brent price of crude oil since 2011 would have been higher by as much as $10 per barrel (see Figure 2). As large as this effect is, it pales in comparison with the decline in the oil price that took place after June 2014.

To date, Saudi Arabia’s strategy for dealing with the US fracking boom has been to preserve its market share and to avoid idle capacity. There is no sign of the country curtailing its oil production nor is it likely that such a strategy would help preserve Saudi oil revenue. Instead, the Saudi government has dealt with the decline in oil revenues mainly by tapping its financial reserves.

The central question for Saudi policy-makers is to what extent the country should rely on external borrowing and to what extent it should cut public spending. Economic theory indicates that it makes sense for Saudi Arabia to borrow in response to a temporary fall in oil prices. But if the decline in the oil price were expected to be permanent, external borrowing would not be the appropriate response and the adjustment instead would have to come from fiscal retrenchment.

Thus, the answer to the question of how much fiscal adjustment Saudi Arabia requires is ultimately determined by how long low oil prices are likely to persist. How soon the oil price is expected to recover depends on why it declined and how important those determinants will remain in the future.

For example, to the extent that the fracking boom influenced the price decline, the question is how long the boom can persist at current prices with many commercial tight oil producers experiencing heavy operating losses. It also depends on how quickly these firms could resume tight oil production at higher oil prices, if they were forced to close down.

But even if the current low oil price were to put shale oil producers out of business, such an outcome might be short-lived. An obvious concern is that shale oil production is likely to resume as soon as world oil prices recover sufficiently, making it impossible to remove permanently the shale oil competition for as long as there remains easily accessible shale oil in the ground.

At present, the only countervailing force on the supply side is that production in many other oil-producing countries will continue to fall over time, as conventional fields – for example, in Norway and the UK – are depleted. Over time, however, it seems likely that these continued production declines will make room for higher oil production in countries such as Iran, Iraq, Saudi Arabia, Russia or the United States. This adjustment will be accelerated by worldwide cutbacks in investment in the oil industry.

The problem for Saudi Arabia is that there is a good chance that the process may take longer than its foreign exchange reserves will last. Thus, there seems to be no alternative to some considerable measure of fiscal retrenchment in the foreseeable future. The same argument applies even more forcefully to other Arab oil producers faced with more foreign debt and lower foreign exchange reserves.

A natural starting point for such reforms would be for policy-makers to reduce or even phase out domestic subsidies on energy consumption. In fact, implementing such reforms is likely to be politically easier in an environment of falling oil prices. The United Arab Emirates, for example, have already successfully aligned their domestic fuel prices with prices in global markets. Many other Arab oil-producing countries have yet to implement similar reforms.

Clearly, however, such reforms will not be enough, given the magnitude of the oil revenue shortfall that has accumulated in recent years. There will have to be more fundamental changes to the welfare state in countries such as Saudi Arabia and implementing these changes will be politically challenging.

One problem is that many Arab oil-producing countries lack an income tax base. Taxing incomes of domestic citizens working in the public sector would be the same effectively as lowering public wages and hence public spending, leaving taxes on foreign workers’ income as the only policy option for raising tax revenue. Thus, much of the fiscal adjustment will have to occur on the expenditure side.

An extended period of low oil prices is likely to cause far-reaching economic changes in Arab oil-producing countries as well as changes in the social fabric, whether these changes are implemented gradually in anticipation of growing financial constraints or are eventually forced by external events.

The obvious concern is that if this transition is not managed well, geopolitical risks in the Middle East may become much more important again. This would contribute to higher oil prices in the long run.

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