Why oil prices are falling

America is the new Godfather of oil.

Saudi Arabia was long known as the Godfather of oil. That was not because they had the largest reserves of oil or the lowest cost of production. The Saudis were feared in oil markets because they alone held excess production capacity, making them the swing producer.

If supply was threatened, only Saudi Arabia could swiftly replace lost production. The oil cartel, OPEC, was similarly kept in line by the standing Saudi threat to deploy excess capacity to flood the market with supply. For decades, Saudi Arabia was the largest and most important oil producer in the world.

That is no longer true. The United States is now the largest producer of oil, pumping more than 12m barrels of oil a day. American output cannot compete with the Saudis on cost but it surpasses them in one important way.

Unlike traditional reservoirs, oil produced from shale requires little upfront capital and can be easily turned on and off. Much of America's new oil supply is therefore highly responsive to prices. America, not Saudi Arabia is the new custodian of excess industry capacity.

If prices rise, shale producers rush to lift output; if they fall, they can switch off the taps. Supply shocks are, in theory, inconsequential.

While it is true that oil supply has increased and demand has decreased, that has been happening for at least a year. Oil prices may be falling for another reason: the market is unwinding the security premium built into oil prices as belief in the shale revolution is accepted. America is the new Godfather of oil.

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