Why oil prices are rising
Posted June 17, 2009 at 9:53 am 
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There’s a fair amount of consternation in energy circles right now regarding rising oil prices. The spot price for WTI at Cushing ended the day yesterday at $70.46 per barrel. That price marks about a 40 percent increase since May 1, and it’s more than double the price when oil bottomed out in late December at $30.28 per barrel.
In and of itself, oil at $70 per barrel doesn’t carry the same shock value as it did back in late 2005 and early 2006, when nominal oil prices first crossed that threshold. Having seen oil prices top $147 per barrel last year, most Americans are probably desensitized somewhat to double digit oil prices. However, for those who track energy markets closely, there is a somewhat confounding nature to the recent run-up in oil prices.
For starters, industry oil stocks in OECD countries remain at extremely high levels—around 62 days of forward demand cover at the end of April according to IEA and at 61.3 days currently, according to industry analysts. In general, OPEC has long argued that forward cover around 53 days is indicative of a well balanced oil market. This chart gives a good sense of just how high OECD stock cover is today compared to recent years. (And to be clear, OECD stocks do not include the 110 million barrels of crude oil and refined product (70/40, respectively) in floating storage at sea right now. That’s oil that is simply waiting for a buyer as oil companies speculate on higher future prices while the price curve is in contango.)
In the U.S. specifically, the most important market for oil consumption in the world, most indicators are equally gloomy. Take a look at today’s EIA data release. Although industry stocks of crude oil have fallen slightly for the past several weeks, U.S. crude oil stocks are still the higher than at any time in since 1990. Meanwhile, U.S. demand for petroleum products is averaging about 1.2 million barrels per day less than last year through the first six months—that’s a 6 percent fall off.
So why are oil prices rising?
It’s easy to blame bogeymen like rampant speculators and OPEC production cuts. To be sure, OPEC has cut a substantial amount of supply from the market. But again, with stocks so high, it isn’t as if OPEC cuts are truly biting into the supply-demand balance. In essence, the OPEC cuts (targeted at 4.2 million barrels per day since the start of the economic downturn) have largely served to sop up excess supplies as global oil demand plummeted from 86 million barrels per day in 2007 to a forecasted 83 million barrels per day in 2009.
Next, here is a great FT.com note covering the speculation issue. The article does point out that assets under management in U.S. ETFs have once again reached the same levels they hit during last year’s peak. But there is an equally compelling set of data from IEA that suggests commodity investors may increase the amplitude of price swings, but they don’t drive the trends.
Ultimately, we don’t think either of these explanations—OPEC cuts or speculators—offer a compelling rationale for rising oil prices today. Instead, a recent presentation from the head of exploration and production at Royal Dutch Shell offers a much more jarring—and probably more realistic—explanation in our opinion. Below are three charts from the full presentation. Keeping in mind that this presentation is based on the portfolio of just a single (albeit huge) company, take a look at Figure 1.
Beginning in 2005, natural gas begins to overwhelm oil in terms of resource additions. In fact, this particular trend is not entirely out of line with a number of other global majors. Vast oil reserves in Saudi Arabia, Iran and elsewhere are effectively off the table for the IOCs, and most of the conventional oil in open markets like the U.S., Norway and UK has already been produced. True, unconventional supplies like oil sands are available, but developing those resources is time-consuming and costly. So many IOCs are looking to gas as the future, and Shell in particular has bet heavily on gas-to-liquids (GTL) in order remain competitive in liquid fuels markets in the future. (This Reuters article from 2007 placed the cost of Shell’s 140 kboe/d Pearl GTL facility at $18 billion.)
Next, take a look at Figure 2.
Again in 2005, a major shift occurs. From that point forward, much of Shell’s exploration-based resource additions are occurring within the OECD. But most OECD resources are among the world’s most costly to develop. EIA has estimated the break-even price for Gulf of Mexico deepwater to be about $70 per barrel. Total has said it needs oil prices at $80 per barrel to invest in Canadian oil sands. And projects in Norway are moving into ever-harsher environments offshore that require complex and sophisticated equipment to deal with extreme temperatures and sea ice, not to mention Norway’s strict carbon regulations which are pushing companies into expensive carbon capture and storage technologies.
Figure 3 sums up the effects of the first two charts.
According to this figure, the weighted average oil-equivalent price for profitability in new Shell projects is close to $50 per barrel! For about one fourth of the company’s planned portfolio—which includes deepwater and oil sands—the profitable oil price is between $50 and $70 per barrel. Only onshore natural gas development is balancing out costly oil development and keeping weighted average costs from being much higher.
Here’s the bottom line: markets understand the data in these figures.
New oil supplies are not typically accessible in the places where they are cheapest to develop (OPEC). And in the few places where new oil supplies are open to development, geology is forcing costs up dramatically—so much so that some of the most advanced international oil companies in the world are turning to gas for profitability.
But for as much oil as OPEC has in proved reserves, the non-OPEC countries still produce about 60 percent of the world’s oil every day. As the cost of developing that 60 percent goes up, the cost of oil for consumers is going to go up. In fact, traditional economic theory would place the world price of oil right at the cost to develop the marginal barrel, which today is a non-OPEC barrel of oil sands.
In that context, $70 seems about right. In fact, it might even be low.
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