How plunging oil prices have created a volatile new force in the global economy

He’d spent years touting his vision that America would one day dominate one of the world’s most powerful markets. And when Harold Hamm, a pioneer in discovering vast reserves of shale oil under American soil, took the stage in front of several hundred oil luminaries, he never acknowledged that the narrative was in doubt.

“For the next 50 years, we can expect to reap the benefits of the shale revolution,” Hamm said one day this spring. “It’s the biggest thing that ever happened to America.”

But away from the stage, the US oil industry – and Hamm – was in crisis.

In the previous six months, Hamm, founder of oil giant Continental Resources, had lost $6.5bn, more than one-third of his net worth. The industry that Hamm had helped create was facing its greatest test in a frantic race to stay profitable as rival Saudi Arabia worked to drive down oil prices and, according to some analysts, undermine America’s oil industry at the most important moment in its history.

Behind the low price of a gallon of gas at the pump this summer lies a competition worth trillions of dollars that is capable of swinging the geopolitical balance of power. On one side are Hamm, a famous wildcatter, and other American oilmen who rode the discovery of hydraulic fracturing to tens of billions of dollars of wealth and a promise of, in Hamm’s words, ending the “disastrous” days of Saudi Arabian control. On the other are the Saudis and their allies in the Organisation of the Petroleum Exporting Countries (Opec), which are trying to stem rising US oil power and maintain their 40 years of dominance.

This month, the cost of West Texas Intermediate oil, a US benchmark, has been hovering at just over $50 a barrel – down from about $110 over the past year. Meanwhile, the number operating oil rigs in the country has fallen to just 645. That was lowest rig count in almost five years, down from more than 1,500 a year ago. Opec said last month that it would continue to pump 30m barrels a day, despite low prices, sending a strong signal to US competitors that it had no plans to let up the pressure on the Americans.

And now there is a new pressure on the scene. The decision to strike a nuclear agreement with Iran, which has more oil reserves than all but four Opec countries, will over the coming months unleash new Iranian oil into the markets. Analysts expect Iran to pump 1m or more barrels a day as a result, so the prospect of the deal has been driving prices down in recent weeks – by about 15% – interrupting a stabilising in the price of oil since the big plunge last year.

Even before the Iran news, the clash between the US and Saudi Arabian energy interests had created a volatile new force in the global economy and unprecedented challenges for the two largest producers. The Saudis need high prices to fund their nation but have lost control of the market because of the oil boom in the world’s largest economy. The United States, after years of easy growth, is grappling with painful adjustments –including tens of thousands of layoffs – with the hope of staying viable amid the price collapse.

At stake is not just the price of filling up a car but America’s energy independence and one of its most vibrant industries. The fallout will ultimately determine whether cheap oil is a mere blip or will continue for years.

In the past, when oil prices fell, the Saudis and other oil-rich states would step in, pulling back on production and letting prices rise. But this time, the price fell in part because of the substantial increase in US energy production. Instead of acting to shore up the market, the Saudis increased drilling themselves, sending oil prices plunging and threatening US drillers who rely on oil prices being high.

“For the last 20 or 30 years, it was almost like Opec could flip the switch and change things as they wanted,” said Mike Terry, president of the Oklahoma Independent Petroleum Association and an acquaintance of Hamm’s. “Well, they don’t have that power anymore.”

Nearly a year into the oil contest, senior players in oil capitals from Riyadh to Houston are making risky bets about their next moves. Riyadh is continuing to pump, even as that puts its own petro economy on shakier footing.

For the US, the risk is that sustained cheaper energy prices will derail what had seemed only months ago like an inexorable energy revolution, one that was helping to power a still-recovering economy.

“A tidal wave scenario,” Ryan Lance, chairman and chief executive of ConocoPhillips, said in Houston, describing the forces that were challenging producers across the world. “The industry is in a bit of survival mode.”

The Saudis have a built-in advantage in this global contest. They have some of the easiest-to-access oil on Earth, including a single field – the massive Ghawar – that produces more oil daily than any other Opec member.

Many state oil companies, from Venezuela to Nigeria, are corrupt, analysts say. Saudi Arabia’s state oil company, known as Aramco, is anything but. Aramco’s facilities glisten with a campus of housing facilities, classrooms and training sites.

In Houston, at the same conference Hamm attended, hosted by consulting firm IHS, an Aramco oil executive made clear that the Saudis, with many advantages over the Americans, were not going to let up during a downturn. Pulling up logos of fallen American companies on the screen – Kodak, Polaroid, Compaq – Muhammad Saggaf warned: “If we look back, we will see history littered with examples of successful companies that were at the front of the race but in a very short period were relegated to the back … because their competitors won the innovation race.”

During the decades of Saudi dominance, crude prices stayed low, but spiked mightily during wars in the Middle East and oil embargoes. More recently, prices reached a new plateau above $100 a barrel given the demand for energy from China and India. All the while, US fracking companies improved their technology to harness oil from regions that were never thought to offer much in the way of energy.

Eventually, amid a slowing economy and a growing awareness that US oil discoveries were enough to make America energy independent – and potentially even an exporter of petroleum – prices began a steady decline. Then, in late November, for the first time, Saudi Arabia embarked on a new strategy, refusing to cut production to prop up prices. That decision turned a gradual price decline into a free fall.

The Saudis were influenced by a bitter memory from the mid-1980s, when declining global demand had led to a similar oil glut. To try to keep prices stable, the Saudis went from producing 10m to about 2m barrels per day. Its customers flocked to other Opec nations, and the Saudis fought for years to get them back.

“We learned from that mistake,” Ali al-Naimi, the nation’s oil minister, said at a March conference in Berlin. “Today, it is not the role of Saudi Arabia, or certain other Opec nations, to subsidise higher-cost producers by ceding market share.”

Aramco declined to comment for this story.

The new Saudi strategy has caused ripples across the world, knocking off pricey drilling operations everywhere from the Arctic to South America. More broadly, lower energy prices have delivered a blow to oil-dependent nations, pressuring state-run oil firms, causing a currency slump in Nigeria, and contributing to major economic contractions in Venezuela and Russia.

Some experts also say that the Saudis are hoping to cut off the fracking boom at its knees. If they’d allowed prices to stay high, US production would have continued to grow rapidly.

“And they’d be asked to cut again and again, losing market share,” said Jamie Webster, a global oil markets analyst at IHS.

The Saudis have huge advantages beyond their plentiful reserves. Hundreds of US companies can’t adjust as quickly as one state-run oil company. Saudi Arabia can bring its oil to market in weeks. US frackers need six months or longer, because their oil is more difficult to access. If US companies choose to raise production, they also face the challenge of coaxing laid-off workers back into the oil fields – in some cases after they’ve returned to their home states and found new jobs.

But the choice isn’t simple for Saudi Arabia, which is grappling with a leadership change and a military conflict with neighbouring Yemen. Despite decades of attempts to diversify the economy, oil revenues essentially subsidise the state.

Sustained lower oil prices will “put the Kingdom’s savings from earlier oil revenue booms at risk of depletion”, Khalid Alsweilem, a former investment director at the Saudi Arabia Monetary Agency, wrote in a recent report published by Harvard University’s Kennedy School.

Hamm rose from poverty in Oklahoma, the 13th child of a sharecropper, and spent the early part of his career working dirty oil jobs, cleaning tank bottoms and trucking supplies to drilling sites. But he grew obsessed with the idea of the big strike, the discovery of treasure in the ground, according to The Frackers, a book about the nation’s new oil billionaires. He started a tiny company in 1967 named after his two daughters, used the proceeds to pay for geology classes and learn about computer mapping, and ultimately bought up land on the cheap in hard-to-drill places like North Dakota.

Hamm’s company, renamed as Continental Resources, grew into an oil giant over less than a decade thanks to new but pricey drilling technology that opened access to a previously out-of-reach bounty. “Thank God we had good oil prices,” Hamm said at a Continental event last September, with oil at $97 per barrel.

“One time everybody was looking at the sunset of the [American oil] industry,” Hamm said. “We’ve seen America driven to a new era, if you will.”

But the price collapse has put the United States’ – and Continental’s – continued rise in doubt.

Since last fall, US drillers have shuttered 60% of their rigs, seen share prices tumble with little recovery, and laid off tens of thousands of workers who might not return even if prices were to recover. Only a handful of companies have so far faced questions about their solvency, but they have been furiously cutting projects that are no longer viable. The pullback has been severe enough to slow down the broader US economy, which for years had been powered by oil job growth and investment.

“There was an irrational expectation that the market for US oil was unlimited,” said Michael Levi, an energy specialist at the Council on Foreign Relations. “It led to a lot of ill-advised investment.”

The oil prices of the previous years – $111 per barrel in 2012; $108 per barrel in 2013 – had helped Continental grow at a breakneck pace. In early September 2014, Continental stock hit $80 per share, and Hamm, who owned 68% of those shares, was worth more than Rupert Murdoch.

But then prices started to fold.

The downward slide has left Continental particularly vulnerable because Hamm bet wrong on what would happen in the oil market. As oil began its slide in early November, Hamm believed that oil had reached its “bottom rung”. So he sold off Continental’s hedges, netting $433m in cash while losing his assurances that he could sell oil at a fixed price.

The company, in industry parlance, was “going naked”, fully exposed to the markets. Then, on the day after Thanksgiving, Opec held a meeting in which the Saudis determined that they’d no longer work to balance the market. Though Hamm perhaps saw that part coming, what he didn’t foresee was how the markets would react: they freaked out.

“In hindsight, it was not the right decision,” said Leo Mariani, an analyst at RBC Capital Markets who follows the energy industry.

Continental declined to make Hamm or other executives available for comment to describe company decision-making, but responded to several questions by email.

Warren Henry, Continental’s vice-president of investor relations and research, said by email that “no one anticipated the rapidity of the price drop, in part because it was based on price-cutting actions by Opec members rather than supply/demand fundamentals alone”.

Continental is a much different – and smaller – company than it was a year ago. It’s pressured suppliers to lower their costs and has fewer rigs in fewer places. In the Bakken formation that made Continental famous, operations were once spread across eight counties. Now, Continental works only in a tight cluster where oil is cheapest to come by.

“Last year, I could sit on my deck and count 60 trucks in an hour,” said Jean Nygaard, a Divide County resident who leases her farmland to Continental. “Now, I can drive to work 28 miles [45km] and not see a vehicle.”

Today, the US oil industry is trying to feel out what will happen next. Some figure an increase in oil prices has already been set in motion, triggered by the fact that so many companies have cut down on searching for the next place to drill. Without exploration, companies can maintain production for one or two years. But not for a half-decade.

Hamm has come to interpret the events of the last half-year as a sign of US oil’s staying power. Continental lost $33m in the first three months of 2015, but Hamm says the company will be able to tread water for the rest of the year – and quickly ramp up if oil prices touch $70, something he says “could happen fairly soon”.

“We are adapting well to the new price environment,” Hamm said. “It’s a great time to be in the American oil business,” he added. “America will again be an energy superpower.”

Guardian