The U.S. Fracking Boom: Impact on Oil Prices.

• Author: Frondel, Manuel

1. INTRODUCTION

   Since the outset of the new millennium, the global oil market has experienced significant changes: Due to the surge of petroleum consumption from emerging countries, world crude oil demand has substantially increased, not least driven by China (Smith, 2009). In fact, global oil demand increased by more than 25% between 2000 and 2017, from about 76.9 to 98.2 million barrels per day (mbd), with China accounting for more than 8 mbd of this increase (BP, 2018). On the supply side, while about one third of crude oil production still originates from the member countries of the Organization of the Petroleum Exporting Countries (OPEC), the production of Non-OPEC countries strongly increased in the last decade, most notably as a consequence of hydraulic fracturing. In conjunction with horizontal drilling and micro-seismic imaging, the use of hydraulic fracturing, which was originally developed for the exploration of natural gas, allows for tapping into oil reservoirs that are trapped in shale siltstone and clay stone formations (Maugeri, 2012). Oil extracted on the basis of these techniques is commonly referred to as tight or shale oil to differentiate it from crude oil obtained by conventional drilling methods.

   To date, the commercial use of this set of technologies, usually subsumed by the notion of fracking, has been limited to the U.S. (Kilian, 2017b), where the steady decline of crude oil production as of the 1970s was reversed by adopting this technology. Owing to fracking, U.S. crude oil production almost doubled over the past 15 years (see Figure 1). Thus, the advance of fracking was often called a game changer for the global oil market. Its importance may even further increase given that numerous other Non-OPEC countries contemplate intensifying the usage of this technology. Notably, in addition to Australia, India, and several European countries, such as the UK, Russia, one of the world's largest oil producers, has commenced investigating the potentials of fracking (EIA, 2013). As a result, it is frequently announced in the press that OPEC's market power has drastically diminished.

   Using monthly data on the U.S. oil market spanning from January 2000 to December 2016 and taking the demand side as given, this paper modifies the supply-side model developed by Kaufmann et al. (2004) to explore the effect of fracking on world oil prices. To gauge the short-run effects, we employ a two-step Error Correction Model (ECM), while the long-run relationship between the crude oil price and fracking, as well as various OPEC supply factors, is estimated via standard and dynamic OLS methods. The key finding of our correlation analysis is a statistically significant negative long-run relationship between increased U.S. oil production due to fracking and world oil prices. A similarly negative influence is found for OPEC supply volumes that exceed the stipulated OPEC quota, indicating that OPEC still matters.

   Although there is a vast oil market literature, fracking only recently has become a topic of interest, and the economic impact of the emerging fracking oil supply is not widely analyzed yet. Three notable exceptions are the review article by Kilian (2017a), the empirical study of Kilian (2017b), and the oil price forecasts of Baumeister and Killian (2016) on the basis of a vector autoregressive (VAR) model. Kilian (2017a) provides an overview of the impact of fracking on U.S. oil and gasoline prices, arguing that the negative effect of increased U.S. shale oil production on the crude oil price is likely to have been near $10 per barrel.

   Using a novel econometric technique, this estimate is confirmed by Kilian (2017b), who also estimates the cumulative losses of Saudi Arabian oil producers due to fracking at over 100 Billion US Dollars. Highlighting the role of economic activity for oil prices, Baumeister and Killian (2016) provide quantitative evidence that a slowing global economy, rather than supply shocks, was the dominant reason for the $49 cumulative decline in the Brent price per barrel between June and December 2014. These authors find that "$24 of the cumulative decline is unambiguously explained by a weakening of the global economy, which resulted in lower demand for crude oil" (Kilian, 2017a: 198). Our study complements this strand of the literature by quantifying the impact of the advance of shale oil on the oil price using standard and dynamic OLS methods and (Vector) Error Correction Models, the results of which are employed to simulate the development of global oil prices in absence of the shale oil boom.

   In contrast, former studies predominantly focussed on OPEC behavior. For instance, the articles by Kaufmann (1995), Kaufmann et al. (2004), and Dees et al. (2007) all investigate OPEC's influence on oil prices over the medium- and long-run. These authors find the two most important decision variables to be the OPEC production quota, as well as the rate at which OPEC adds production capacity, which would signal tightness in the market. Dees et al. (2007) additionally point out that a breakdown in the cooperation of the OPEC cartel results in a sharp drop in the crude oil price, as competition among OPEC countries leads to supply quantities that surpass demand and go into stocks.

   The following section provides a concise summary of the rise in U.S. oil production owing to fracking and OPEC's behavioral reaction to the increased use of this technology. Section 3 explains the methods applied, followed by the presentation of our estimation results in Section 4. The last section summarizes and concludes.

2. U.S. CRUDE OIL PRODUCTION AND OPEC BEHAVIOR

   Currently, the only country that permits fracking on a large scale is the U.S., whereas many other countries are highly reluctant to employing this technology because of its potentially negative implications for the environment, notably potential hazards due to water pollution and seismic tremors--see the review article by Jackson et al. (2014) for a discussion of these environmental and health issues. France and Germany, for instance, have implemented a ban because of perceived health risks due to fracking. In contrast, other countries, such as the UK and Australia, have recently modified political regulations to allow for fracking (EIA, 2013).

   With the beginning of the surge in shale oil production in late 2008 (Kilian, 2017b), U.S. crude oil production steadily increased until the end of 2014, with the share of shale oil in total U.S. production rising from about 6% in January 2000 to almost 50% by the end of 2014 (see Figure 1). In fact, November 2008 marks the reversal in the long-standing decline in U.S. oil production, a reversal that is largely due to the U.S. fracking boom (Kilian, 2017b).

   This boom exerted substantial pressure on the price of the light crude oil West Texas Intermediate (WTI), whose price is the key indicator for U.S. crude oil, with the result that the prices of WTI and Brent, the benchmark for European crude oil, drifted apart between 2010 and 2015 (Figure 2). Prior to 2010, both price indicators had more or less the same level, whereas afterwards WTI was significantly cheaper than Brent oil until the end of 2015, with differences in prices sometimes amounting to $ 10 per barrel or even more.

   Recent studies suggest that this difference was the result of the increased shale oil supply, paired with a bottleneck in refinery and oil transport infrastructure (Borenstein and Kellogg, 2014; Kilian, 2016). This price differential between WTI and Brent initially reflected the excess supply of light crude oil in Cushing, Oklahoma, where the WTI price is measured. Owing to the lack of pipelines to the refineries, this oil was stored in a location where it could not compete with imports (Kilian, 2016:193). At the end of 2015, the price differential virtually vanished due to the expansion of transport infrastructure. It allowed light crude oil that used to be landlocked in the center of the U.S. to reach existing refineries.

   While world oil prices shrank by $49 between June and December 2014, under the lead of Saudi-Arabia, OPEC changed its strategy from defending oil prices to defending market shares and refrained from its former behavior of curbing oil production to attempt to stabilize world oil prices. Prior to this change, the OPEC members usually agreed upon individual production allocations for each country and, hence, an upper limit for the total OPEC production level, the OPEC quota, thereby assuming that OPEC can maximize its profits when the production quota is optimally set (Griffin, 1985).

   Employing the quota as a key instrument, it is the declared aim of the OPEC cartel "to coordinate and unify the petroleum policies of its Member Countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry" (OPEC, 2018). There is evidence, though, that OPEC is not operating as a perfect cartel: By comparing various potential market structures that could explain OPEC behavior, Smith (2005) points out that the OPEC members operate much more like a non-cooperative oligopoly than a frictionless cartel. Moreover, while according to Kaufmann et al. (2008) OPEC uses its market power by appointing quotas, thereby influencing both oil production and prices, these authors also find that OPEC behavior has some competitive elements, as for example higher oil prices lead to increasing production of individual OPEC countries.

   The OPEC quota was regularly varied and posted on the organization's homepage until November 2007, but was updated only irregularly thereafter. For instance, with an OPEC crude oil production of 24.85 million barrels per day (mbd), the official quota of January 2009 remained in place until...