The Catch-22 of “Low” Oil Prices
The best piece of energy journalism we’ve seen this week comes from John Dizard in the Financial Times, entitled ‘Saudi America’ remains a Washington fantasy. Dizard makes a number of points undermining the unbridled enthusiasm we’ve seen here in Washington over the supposed ability of the domestic production boom to result in lower oil prices for Americans, and discusses how the oil-market is in an unfortunate condition forcing it to self-regulate to keep prices high. “He (Bob Brackett, a geologist at Bernstein Research) considers the possibility of Iran’s suddenly turning on a million barrels a day of additional production. “That would take $10 or $15 out of world oil prices, and markets tend to overshoot. From his $95 a barrel US price assumption for next year, given the American industry’s cost structure, that would lead to a 15 per cent reduction in the number of rigs drilling for shale oil, and a smaller decrease in the rise of US oil production. Even with a more optimistic (for the oil producers) assumption in the price of the stuff, he sees production in the formerly hardscrabble, now rich, state of North Dakota topping out in 2019 at 1.2m barrels per day. Hardly “Saudi America”. With declining conventional and offshore Gulf production, that means US “energy independence” will remain a Washington fantasy.” In short—increasing supply (domestic or otherwise) will do little to drive down prices, because numerous forms of unconventional production simply become uneconomical once oil prices drop below a certain threshold. As we know, prices are set at the intersection of the supply and demand curves—market fluctuations will cause both curves to shift. In the case of increases in oil supply, the supply curve shifts downward, meeting the demand curve at a lower price point. Oil demand is famously inelastic, which means that changes in supply can have dramatic price impacts (which is one of the reasons why it’s so easy for OPEC to maintain its desired price floor—the inelasticity of oil demand means that prices are highly responsive to small supply constrictions). Compared to commodities with flatter demand curves, smaller supply changes have more significant price impacts. This would likely be true with or without OPEC’s influence, due to the importance of petroleum to our transportation system—but as the graph demonstrates, OPEC tightens the supply curve. OPEC’s control over almost all of the world’s remaining conventional reserves is one aspect (and production of one-third of the 90 million barrel per day global market)—to which the basics of supply and demand largely do not apply. Decisions about the management and exploitation of these resources are determined by autocratic regimes rather than profit-seeking firms. Their production costs can be as low as single-digit numbers per barrel, and they benefit from (and are increasingly dependent upon) global prices in the triple digits. Meanwhile, the forces impacting the remaining 60 million barrels per day produced by non-OPEC nations can be shown with extremely steep demand and supply curves (reflecting inelasticity of demand, and price-sensitivity of suppliers). Add to this very rudimentary model all the other factors which contribute to volatility—as we all know, a war in the Middle East, an environmental disaster, or even slow economic growth can all cause significant price movements, reflecting changes in the world’s current and (expected) future demand. But something important to consider is that because oil prices have recently (within the past few years) risen and remained at such high levels, many new and cost-intensive production methods have come into play. This is best exemplified in the United States, where the oil industry is more aggressive and operates at the cutting edge of technological innovation. Firms have seized the opportunity to utilize the sustained high prices to put new technologies into practice, but economically, two results emerge. This is where we see the impacts of a highly price-sensitive supply curve—meaning that even relatively modest price drops will make many unconventional hydrocarbons unprofitable. The Canadian Tar Sands are a clear example of this—production took a dive when oil prices collapsed after the 2008 financial crisis, and costs of $75-$90/barrel were non-economical to produce. This illustrates the second point: the creation of another kind of “soft floor” under oil prices—buoyed not only by OPEC’s manipulation, but also by the increasing costs IOCs must pay to dig deeper and squeeze fields further.
- Offshore leasing rates are astronomical: Total is currently leasing a Deepwater rig at a rate of $700,000 per day off the coast of Greece.
- Barclays equity research reported earlier this year that current rig leasing rates are at historical highs, thanks to ample demand in the Gulf of Mexico, West Africa, Brazil, and other emerging deepwater basins.
- According to Rigzone, 85 percent of the world’s rig fleet is now being used, up from 82 percent one year ago.
- New bouts of deepwater platforms in the Gulf are costing companies billions of dollars, and are so large they can be seen from 20 miles away.
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December 5, 2013
December 5, 2013
OPEC’s Market Power Remains Strong as Ever. Here’s Why.
December 4, 2013
December 4, 2013
Iran Deal: Scant Relief and Downside Risks
November 27, 2013
November 27, 2013