Oil Prices Are Dropping: Here's What Could Be Coming

Even Spindletop went bust.
Even Spindletop went bust.

Once upon a time a whole bunch of Texas oil people started telling themselves stories about the latest shale boom. This one, they assured each other, would never go bust. The price of oil would stay high forever and we would all live here in the city at the center of the land of milk and honey and Texas tea in wealth and plenty.

Well, that was a fun story, but in the last few weeks reality has sunk in as the price of oil has dropped like a stone. On Monday oil sank to $55 a barrel, the lowest the price has been since May 2009. Texas just hit over a billion barrels of production for this year and the state alone is the sixth largest oil producer in the world. Texas has been the black beating heart of all this plenty, and now Texas and the other states are bracing themselves to suffer from the fallout. By all accounts, we could be in for quite a jolt.

So how did this happen? Well the surface answer is that the Saudis did it to teach the U.S. shale operators a lesson, Bill Gilmer, Director of the Institute for Regional Forecasting in the University of Houston's Bauer College of Business, says. "The Saudis haven't announced any sort of public policy here, but it's increasingly clear that they're helping their friends and punishing their enemies, probably at a substantial price to themselves," Gilmer says. "Low oil prices punishes Iran, ISIS, punishes what could be regarded as enemies. Texas and North Dakota probably go on the list of adversaries. This may very well be sort of a run at U.S. shale production."

The Saudis have the second largest proven oil reserves in the world and they produce huge amounts of oil out of a few very large fields. All of this means that the Saudis have a ton of power and their decision about how much oil they produce can have a huge impact on the world, Gilmer says. Because of that the Saudis have acted for years as swing producers, pumping more oil into the markets when needed -- thus sinking the price and giving the markets more oil -- or cutting back when needed -- thus taking care of any over-production so that the price wouldn't get too low. Gilmer says it looks like the Saudis are forcing the U.S. shale industry to take their place as the swing producers.

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The thing is, of course, while that isn't such a big deal for the Saudis to make production adjustments this way or that -- the Saudis have a centralized market comprised of just a few very large fields, so production is relatively easy to control -- the impact will be a lot more shattering as the U.S. shale industry steps into those shoes. "It's a much messier process here and one that could be repeated over and over again. I think a lot of people are looking at this as a one time event, but I don't think that's it. I think it's going to be a long-term process of U.S. shale taking on the role of swing producer," Gilmer says. "It changes the game. A lot of shale will be explored much more slowly because of this."

In the meantime, the U.S. shale production industry is in the process of having to sober up, with Texas leading the way by gulping the metaphorical black coffee and trying to shake off that petroleum haze. "I've monitored the Houston economy for 25 years, and I can't think of a time of more uncertainty about where we're headed," Gilmer says. "We don't know what the Saudis are up to or how the industry will actually react. We haven't been through this kind of downturn since the new shale technology."

A couple decades ago, popular wisdom held that Texas's best oil production days were long behind it. The 1980s oil bust had been the end of an era and most people in the industry thought the glory days of big oil money were long gone in the Lone Star State. But then George Mitchell's company figured out how to use horizontal drilling and hydraulic fracturing to get at the oil locked in the dense brittle shale plays. The wells were expensive to produce, but once oil prices soared that wasn't really an issue since the shale plays produced enough at $70 a barrel and up for companies to make a tidy profit.

The shale boom put Texas on the map again where oil was concerned. It helped both Houston and the state coast through the Great Recession relatively unscathed, and people have been coming to Houston in droves in recent years to get in on the action. And all along, the industry people were sanguine about the future, because oil prices were never going to fall and a bust was never going to happen, according to most of them.

But of course that hasn't turned out to be the case. When oil prices started slipping a few months back, it was like a surge of adrenaline through the veins of industry. It wasn't a problem though, everyone reassured each other. Shale plays were expensive to drill but oil companies could still make a profit at $80 a barrel, or at $70 or even $65 if they had to. They all told each other everything was fine and then watched helpless as oil slipped below $60.

Ed Hirs, a professor of energy economics at UH, noted that oil companies are already reacting to the market. British Petroleum announced layoffs while Conoco Phillips has announced a smaller capital budget for next year, Hirs says. The intended merger between Halliburton and Baker Hughes is one of the first big mergers announced, but it probably won't be the last one, he says. "Companies need to be in here for the long run if they can. The shale plays will return to profitability in time. It may not come in time to rescue the guys who are invested heavily in the shale plays, but it will come," he says. "Once you get going in one direction it's hard to turn things around."

It's going to be a big slow down for the whole state, Gilmer says. But things could get particularly tough once you leave the Gulf Coast and get into places like Tyler, Amarillo, Lubbock and the Permian, where there's little other industry to pick up the slack.

People in those places will have to move to where construction is happening -- mostly along the Gulf Coast -- to get the jobs, Gilmer says. However in Houston it's going to be the white collar office workers who feel the low oil prices first, he says. "One side of town, the blue collar, east side will boom and the west side will feel like a recession. The energy corridor, a lot of people who work in office buildings will really feel the brunt of this."

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