Many industry experts predicted that US shale oil companies would quickly go bankrupt when oil prices started to decline in the last quarter of 2014. Jobs would be forever lost, financing would dry up and OPEC would remain the world’s oil cartel. Instead, merger activity has been relatively muted, companies are driving down costs, and drilling activity appears to be picking up agai as the oil market finds its equilibrium. All this means that US shale is likely to remain a permanent feature of the global energy landscape, with the US, not only OPEC, as the new “swing producer” in the global oil market. (To read more about OPEC, see article: Meet OPEC, Manager Of Oil Wealth.)

What is a swing producer?

A swing producer is one who quickly, easily and, most importantly, cheaply increases and decreases oil production to meet shifting global demand patterns. This term is most often used when analyzing the “call on OPEC,” or the amount of oil OPEC needs to supply to (or withdraw from) world markets to balance supply and demand and stabilize prices. According to the US Energy Information Administration (EIA), “producers in non-OPEC countries are generally regarded as price takers, that is, they respond to market prices rather than attempt to influence prices by managing production. As a result, non-OPEC producers tend to produce at or near full capacity and so have little spare capacity.” In contrast, countries with spare production capacity are better positioned to influence global prices by altering their production levels as needed. In essence, they are able to “swing” production levels in whichever direction the market requires to achieve balance. (For a more in-depth understanding of this process which impacts the price of oil, see article: What Determines Oil Prices?)

OPEC's Spare Production Capacity

Traditionally, OPEC countries have filled the role of global swing producer, since they were the only ones with spare production capacity. The cartel, established in September 1960, is often looked to as a source of stability in the global oil market that amps the number of available barrels of oil when supply is scarce and takes production offline when supply is plentiful. Historically, they have been willing to do this because it is the cartel’s marginal barrels that flow in and out of the market in this balancing role. By way of example, the chart below shows OPEC’s declining spare production capacity in Q1 2015.

This group of oil-producing nations has been maintaining high production levels (hence reducing spare capacity) since the end of last year to keep oil prices low in a bid to force high-cost US shale producers from the market. They are doing this because, the cartel has said, they are not in the business of subsidizing high-cost producers, so they are keeping their barrels on the market to maintain market share. The result of this decision has been declining oil prices. (See article: OPEC's Decision Sends Oil Stocks Lower.)

However, the US shale revolution has changed the global energy landscape and it is not only OPEC that now has spare production capacity. As oil prices have declined, the US has scaled back project development, creating its own spare production capacity. Increasingly the US will be in a position to ramp production up or down as market conditions demand. US production is already starting to decline, having peaked in March according to the EIA, which is also adding spare production capacity in the US.

US as Emerging Global Swing Producer

The debate is still open as to the ability of the US to play a truly effective swing producer role. Some suggest the critical factor is the reaction time to changing market conditions. “When you think of a swing producer, you think of OPEC and you think of spare capacity that can be turned on and off,” said Trisha Curtis, director of oil and gas research at Energy Policy Research Foundation Inc. in an interview with Bloomberg. “Relying on flexible, low-cost opportunities that can stop and start on a dime will be critical as US drillers become the world’s swing suppliers”, ConocoPhillips (NYSE: COP) chairman and chief executive officer Ryan Lance said on April 8 during the company’s Q1 conference call.

Debate is open about the US oil industry’s ability to work in a coordinated fashion and in a timely manner, however. For example, Mihir Varia of Petroleum Services says it can take up to six months to get US shale production back online once it is shut in, according to an interview he did with the Financial Times. For some key stakeholders, this is too long a delay to make it possible for the industry to be able to effectively replace OPEC’s “swing” role in the global market.

The US does have a large number of shale oil wells that are sitting idle, as it waits to begin production when oil prices eventually rise. Experts have come to call this the “fracklog”. Bloomberg reports that from North Dakota to Texas, there are more than 3,000 wells that have been drilled but not tapped, based on estimates from Wood Mackenzie Ltd. and RBC Capital Markets LLC. This backlog of unfracked wells could allow the US to ramp up production in a higher oil price environment. The key question is, how fast. Analysts such as Mike Wittner, head of oil research at Societe Generale SA in New York, say there is a big difference between OPEC acting in unison and the fragmented US oil industry serving its self-interests, according to Bloomberg. Overall, it seems the general consensus is that the US lacks the agility of OPEC to be a truly effective force on the global oil markets. (See article: Fracking Can't Happen Without These Companies.)

US' Improved Drilling Efficiency

It may be too early to count the US oil industry out just yet, however. Recent data from the EIA’s drilling report shows that the US shale industry continues to generate remarkable efficiency gains. As the chart below shows, the oil production per rig in the country’s three largest plays continues to rise, even as the overall rig count drops. In places like Bakken, efficiency gains have already doubled output per rig in just two years, and in the Permian basin, efficiency gains are accelerating.

This has largely been possible because of improvements in technology and partly because Permian is home to multiple producing zones stacked on top of each other, allowing drillers to tap oil at different depths from the same well, according to David Zusman of Talara Capital in a Bloomberg interview. It is this improved drilling efficiency that gives US shale a competitive advantage and makes it possible to manage production at varying market price points. This is essential to be a swing producer.

Additionally, the industry is working hard to drive down costs, which helps lower the break-even oil price needed to be profitable, and gives producers greater operating flexibility. For now, the general consensus is that $70 per barrel is the magic number. Many industry participants such as Harold Hamm, chief executive of Continental Resources (NYSE: CLR), see US production ramping up only in an oil price environment of $70 per barrel or more. For now, US players remain price takers, altering production based on market signals. Greater production efficiency and better control over supply could eventually see the US in a more competitive role with OPEC, however.

The Bottom Line

OPEC is facing competition from US shale like never before. Experts have been expecting the cartel's control of the market to end, arguing that cartels do not last forever. 2015 will determine which group is the real swing producer in the global oil market. If OPEC is to remain dominant, its ability to retain this influential position will most likely come from a greater agility in reacting to market forces compared to the US shale industry. On the other hand, it is too early to say that the US doesn’t have any role as a new swing producer. In this lower oil price environment, the US delayed project development. But with efficiency improving, a rebound in price above $70 per barrel seems to be the magic number that will cause US drilling to accelerate. It could yet turn out that in such a scenario, it is the US shale industry that will be reacting while OPEC remains an observer.