A really good market commentary by Goldman Sachs on the state of the oil markets points out that capital has become the marginal adjustment in the oil markets. Prior to the shale revolution, the price tended to be balanced around the marginal barrel of production, which in turn was micro-managed by the major producers (OPEC in particular). In this environment, barrels would be removed or added based on the target price for the major producers given their associated quotas (albeit with some cheating among the minor players). The key was that external barrels outside of OPEC never really altered the price picture significantly. Fast forward to today, and we could not be in a more different world. The shale boom in the U.S. has minimized the influence of the major producers (Saudis) as swing producers thus leaving the oil markets susceptible to the total global barrels produced. Goldman astutely points out that the barrels coming from shale production are driven by the capital employed in these very fast producing, short-lived reserves. Unlike deep, long-lived traditional oil reserves, the economics of shale plays can thus shift much more rapidly. If you think about it, the shale boom is reminiscent of the fibre optic cable buildout during the late 90’s in that they were both liquidity fueled production booms built solely on the access to capital rather than the necessity of immediate demand. The above got us thinking on several fronts about what larger takeaways we can draw from the sharp decline in oil prices. 1) The decline in oil cannot be extrapolated to other non-related parts of the commodity complex 2) The decline in the price of energy will not sustain non-economic production across the commodity complex-this is driven by the spot and forward price curve of the individual commodities 3) As we pointed out in an earlier post, the falling price of oil is not indicative of rapid deflation but rather is an outgrowth of the massive liquidity injections by the Fed and other Central Banks 4).The dislocation in the price of oil has vast implications for global geopolitics, the immediate impact of which we probably will not be able to foresee.