Introduction (Chart 1)

Recent developments in the oil market, such as the US shale revolution and growing concerns about
carbon emissions, require a reevaluation of traditional principles and beliefs.

Four core principles that have guided the analysis of the oil market in the past are outlined.

The oil market has undergone significant changes in the last 10 to 15 years, rendering the previous
principles less useful. The US shale revolution, driven by hydraulic fracturing techniques, has led to
rapid growth in on-shore oil production and played a key role in the collapse of oil prices.

Concerns about carbon emissions and climate change are gaining prominence and could impact
long-term demand for fossil fuels. US shale oil production currently accounts for less than 5% of the
global oil market but has significant potential to impact global oil market dynamics. It is necessary to
update analytical tools and principles to account for the "New Economics of Oil."

Remarks:

• Recent developments in the oil market require a reevaluation of traditional principles and beliefs.
• Four core principles that guided the analysis of the oil market in the past are outlined.
• The oil market has undergone significant changes in the last decade or so.
• The US shale revolution, driven by hydraulic fracturing, has led to rapid growth in on-shore oil
production.
• US shale oil production accounts for less than 5% of the global oil market but played a key role in
the collapse of oil prices.
• Concerns about carbon emissions and climate change are gaining prominence and could
impact long-term fossil fuel demand.
• Analytical tools and principles need to be updated to reflect the "New Economics of Oil."
Principal 1: Oil is an exhaustible resource (Chart 2)

The hoteling principle assumes oil is an exhaustible resource with a known total stock of recoverable
oil resources. Estimates of recoverable oil resources are continually increasing due to new discoveries,
technology advancements, and improved understanding. Over the past 35 years, the world has
consumed around 1 trillion barrels of oil, while proved reserves of oil have increased by more than 1
trillion barrels. Existing reserves of fossil fuels, if fully used, would generate more CO2 emissions than
what is considered consistent with limiting global mean temperature rise to 2 degrees Centigrade.

Coal is the highest-carbon fuel and would account for 60% of emissions from burning current coal
reserves. Carbon Capture and Storage (CCS) technologies may help reduce greenhouse gas
emissions from fossil fuel usage. It is unlikely that all of the world's oil will be consumed due to
increasing estimates of recoverable resources and environmental concerns. The relative price of oil
is no longer expected to consistently increase over time.

Technological progress, such as in the US shale industry, allows for the extraction of previously
uneconomic oil resources. Productivity gains in the US shale industry have been significant, with
productivity growth averaging over 30% per year between 2007 and 2014. The nature of fracking, a
standardized and repeated process, resembles manufacturing and may lead to strong productivity
gains. The impact of fracking on the relative price of oil and its applicability to conventional oil
operations outside the US are intriguing questions. Lean manufacturing principles may be applied to
conventional oil operations to improve productivity.

Remarks:

• Oil is considered an exhaustible resource, but estimates of recoverable resources continue to

increase due to discoveries and technological advancements.
• Over the past 35 years, oil consumption has exceeded proved reserves, indicating an increasing
availability of oil resources.
• Existing fossil fuel reserves, if fully utilized, would generate excessive CO2 emissions beyond
acceptable limits.
• Coal is the highest-carbon fuel and would contribute significantly to emissions if burned.
• Carbon Capture and Storage (CCS) technologies may help reduce greenhouse gas emissions.
• The world is unlikely to consume all of its oil due to increasing estimates of recoverable resources
and environmental concerns.
• The relative price of oil is no longer expected to consistently rise over time.
• Technological progress, particularly in the US shale industry, has allowed for the extraction of
previously uneconomic oil resources.
• Productivity gains in the US shale industry have been substantial, averaging over 30% per year.
• Fracking, with its standardized and repeated processes, resembles manufacturing and may lead
to strong productivity gains.
• The impact of fracking on the relative price of oil and its applicability to conventional oil
operations outside the US are interesting areas of exploration.
• Lean manufacturing principles may be applicable to conventional oil operations to enhance
productivity.
Principal 2: Oil demand and supply curves are steep (Chart 3)

Conventional oil supply has limited responsiveness to price changes due to the time lag between
investment decisions and production. Shale oil and fracking have changed this dynamic by reducing
production lags and introducing high decline rates. Shale oil wells have shorter lifespans and decline
at a steeper rate compared to conventional wells.

These characteristics make shale oil more responsive to price changes in the short run. The US shale
revolution has introduced a kink in the short-run oil supply curve, reducing price volatility. Shale oil
acts as a shock absorber in the global oil market, with its output adjusting quickly to price fluctuations.
The high ratio of variable costs to total costs in the shale industry increases its short-run
responsiveness.

Conventional operations have significant fixed investment costs, dampening their short-run supply
responsiveness. Shale oil is the marginal source of supply in the short run but may shift gradually to
other forms of production in the long run. The financial characteristics of independent shale
producers may introduce additional volatility to the market. Independent shale producers have
higher levels of debt and negative cash flows, relying on external finance to fund operations.

US shale has introduced a credit channel to the oil market, making it more exposed to financial shocks.
The availability of funding for shale expansion was influenced by low global interest rates and
quantitative easing. The willingness of banks and creditors to continue funding shale businesses will
affect future shale oil supply. Shale oil has altered the nature of global oil supply, increased price
responsiveness but also exposing the market to financial risks.

Remarks:

• Conventional oil supply has limited responsiveness to price changes due to production time lags.
• Shale oil reduces production lags and has high decline rates, making it more responsive to price
changes.
• Short-term shale oil supply is more responsive to price fluctuations than conventional oil.
• Shale oil's characteristics introduce a kink in the short-run oil supply curve, reducing price
volatility.
• Shale oil acts as a shock absorber in the global oil market, adjusting output quickly to price
changes.
• Shale operations have higher variable costs and lower fixed costs, increasing short-run
responsiveness.
• Conventional operations have significant fixed investment costs, dampening short-run supply
responsiveness.
• Shale oil is the marginal source of supply in the short run, but its importance may gradually
decrease in the long run.
• Independent shale producers have higher debt levels and negative cash flows, relying on external
finance.
• Shale oil introduces a credit channel to the oil market, making it more exposed to financial shocks.
• Low global interest rates and quantitative easing facilitated the funding of the US shale revolution.
• The willingness of banks and creditors to fund shale businesses will affect future shale oil supply.
• Shale oil has changed the nature of global oil supply, increasing price responsiveness and
financial exposure.
Principal 3: Oil flows from East to West (Chart 4)

Oil flows from east to west, but this traditional pattern of trade is changing. Oil demand in the west,
particularly the US and Europe, has been declining due to improved efficiency in motor vehicles. The
US and North America have experienced significant growth in energy supply, primarily due to the
shale revolution.

The US has reduced its energy import dependency, and it is expected to become self-sufficient in
energy by the early 2020s and in oil by the early 2030s. In contrast, China and India are becoming
increasingly dependent on imported energy as their economies grow. China and India are projected
to account for around 60% of the global increase in oil demand over the next 20 years. China is
expected to import around three-quarters of its oil consumption by 2035, and India almost 90%.

These changing energy flows have implications for future energy market demand and financial flows.
As energy flows from west to east, the funds to pay for that energy will travel in the opposite direction,
potentially impacting financial risks and asset prices. The reduction in the US energy deficit has
contributed to the appreciation of the US dollar.

The changing energy flows also have geopolitical implications, with potential effects on relationships
between countries and energy security concerns. China's increasing reliance on energy imports is
likely to influence its foreign relations and policies, such as the creation of the Asian Infrastructure
Investment Bank (AIIB) and the "one belt, one road" initiative.

Remarks:

• Traditional east-to-west oil trade pattern is changing.

• Oil demand in the west is declining due to improved vehicle efficiency.
• US and North America have experienced significant energy supply growth.
• US is reducing its energy import dependency and aiming for self-sufficiency.
• China and India are increasingly dependent on imported energy.
• China and India will account for a majority of global oil demand growth.
• Energy flows from west to east have implications for energy and financial markets.
• Reduction in US energy deficit has contributed to the appreciation of the US dollar.
• Changing energy flows have geopolitical implications and may impact relationships between
countries.
• China's energy import reliance influences its foreign relations and policies.
• Energy flows are changing, with implications for energy markets, financial markets, and
geopolitics.
Principal 4: OPEC stabilizes the oil market

The role of OPEC (Organization of the Petroleum Exporting Countries) in stabilizing the oil market is
being questioned by some commentators. The author argues that the role of OPEC has not
fundamentally changed in the past 20 or 30 years. OPEC's power to stabilize the market comes from
its ability to adjust supply in response to temporary shocks in demand or supply.

OPEC has reduced supply during the 2008/9 recession and the Asian financial crisis to stabilize the
market and boost prices. OPEC can respond to temporary shocks to stabilize the market, but it cannot
sustainably stabilize the market in response to structural shocks. If there were a persistent shock, such
as the mass adoption of electric cars, OPEC's ability to influence the market would be limited.

OPEC's response to a persistent shock would involve maintaining market share and allowing higher-
cost producers to bear the brunt of the demand contraction. The emergence of US shale oil has had
a similar impact on the supply side as a persistent shock. OPEC cannot wage war on US shale oil, and
it has maintained its production target despite plummeting oil prices. OPEC's ability to stabilize the
market in response to temporary shocks remains largely unaffected, but US shale oil's responsiveness
can also help stabilize the market. When interpreting OPEC's response to price changes, it is important
to consider whether the changes are due to temporary shocks or more persistent factors.

Remarks:

• OPEC's role in stabilizing the oil market has been questioned.

• OPEC's ability to stabilize the market comes from adjusting supply in response to temporary
shocks.
• OPEC has reduced supply during recessions and financial crises to stabilize the market.
• OPEC cannot sustainably stabilize the market in response to persistent shocks or structural
changes.
• OPEC's response to persistent shocks would involve maintaining market share and letting higher-
cost producers bear the demand contraction.
• The emergence of US shale oil has had a similar impact on the supply side.
• OPEC cannot wage war on US shale oil and has maintained its production target despite low
prices.
• OPEC's ability to stabilize the market in response to temporary shocks remains largely unaffected.
• US shale oil's responsiveness can also help stabilize the market.
• OPEC's response to price changes depends on whether they are due to temporary shocks or
persistent factors.
Conclusion:

The emergence of shale oil and concerns about climate change require a new set of principles to
analyze the oil market. The "New Economics of Oil" should be based on four key principles.

There should not be a presumption that the relative price of oil will necessarily increase over time
because oil is not likely to be exhausted. The future price of oil depends on whether the productive
processes of shale oil spread to other types of production, leading to rapid gains in productivity.

Shale oil has different supply characteristics compared to conventional oil, being more responsive to
oil prices, which can dampen price volatility. However, it is also more dependent on the banking and
financial system, making the oil market more exposed to financial shocks. The flow of oil is likely to
increase from west to east, which has implications for energy markets, financial markets, and
geopolitics.

OPEC (Organization of the Petroleum Exporting Countries) remains a central force in the oil market,
but its ability to stabilize the market depends on the nature of the shock driving changes in oil prices,
whether it is temporary or persistent.

Remarks:

• The emergence of shale oil and environmental concerns require a new approach to analyzing the
oil market.
• Four key principles for the "New Economics of Oil" are proposed.
• The relative price of oil may not necessarily increase over time because oil is unlikely to be
exhausted.
• The future price of oil depends on whether the productive processes of shale oil spread to other
types of production, leading to productivity gains.
• Shale oil is more responsive to oil prices, which can reduce price volatility, but it is also more
vulnerable to financial shocks.
• Oil is expected to flow increasingly from west to east, impacting energy markets, financial
markets, and geopolitics.
• OPEC remains influential in the oil market, but its ability to stabilize prices depends on the nature
of the shock driving changes in oil prices.