It
pays to recall that after the crash of 2008, 60% of new oil
development projects in the Middle East were shelved because they
would lose money at low oil prices. If the price of oil falls too
far, producers lose their economic incentive.
-- Rice Farmer
Tumbling
oil tests notional price floor: John Kemp
Following
recent falls, oil prices are much closer to the industry's marginal
cost, especially in North America, where light sweet crude futures
are now valued at only a little over $80 per barrel.
12
June, 2012
For
bullish investors, lower prices promise to provide support by
threatening to curb rapid output growth, especially from high-cost
tight oil and bitumen projects across the United States and Canada,
as well as deepwater exploration, unless the global economy enters
another tailspin.
But
basing price forecasts on marginal costs is hazardous, as the
troubled history of predictions for North American gas prices has
shown over the last two years. Henry Hub prices have plunged through
a succession of so-called price floors defined by estimates of
marginal costs, first at $6 per million British thermal units
(mmBtu), then $4, and most recently $2, triggering only very sluggish
cutbacks by producers.
Oil
prices could suffer the same fate. In the short run, commodity prices
often deviate substantially from estimated marginal costs because
both production and consumption are semi-fixed (the result of
previous investment decisions). In the long run, competitive
pressures force convergence, but marginal cost is itself a moving
target, shifting as a result of changes in technology and industry
structure, which are impossible to foresee with any degree of
accuracy so far ahead.
"Our
knowledge of the factors which will govern the yield of an investment
some years hence is usually very slight and often negligible ... We
have to admit that our basis of knowledge for estimating the yield
ten years hence of a railway, a copper mine, a textile factory, the
goodwill of a patent medicine, an Atlantic liner, a building in the
City of London amounts to little and sometimes to nothing; or even
five years hence" John Maynard Keynes wrote in 1936.
"It
would be foolish, in forming our expectations, to attach great weight
to matters which are very uncertain," Keynes concluded ("The
General Theory of Employment, Interest and Money").
Investors
typically fall back on a "convention" of "(taking) the
existing situation and (projecting) it into the future, modified only
to the extent that we have more or less definite reasons for
expecting a change". This system may not be accurate or even
realistic, as Keynes illustrated, but it reduces the enormous amount
of uncertainty that would otherwise paralyze all decisions to make
long-lived investments.
PINNING
DOWN COSTS
It
is notoriously difficult to define marginal costs accurately.
Estimates vary depending on the time frame used, the costs to be
covered, and how marginal production is defined.
In
the short-term, producers only need to cover the variable costs
directly associated with operations. In the longer term, they also
need to cover fixed costs for exploration and development. Estimates
of long-run costs are extremely sensitive to assumptions made about
the cost of skilled labor, materials and equipment, as well as
improvements in technology and efficiency.
Then
there is the question of "social costs", which include a
variety of taxes and royalties imposed by host governments, as well
as price and revenue targets operated by the leading members of OPEC.
Many oil analysts include tax and revenue requirements in their
estimate of marginal costs on the grounds that OPEC producers and
other states need certain minimum prices and revenues to balance
their budgets and avoid social unrest.
But
social costs are not really fixed in the medium term. Social spending
in petroleum exporting states has always been pro-cyclical. Revenue
requirements rise when oil prices are increasing, and tend to fall
when oil prices come under pressure. In other words, prices tend to
drive budgets, rather than the other way around.
Finally,
there is the question of what constitutes marginal production.
Analysts typically focus on a narrow definition of oil (including
production from conventional wells, fracked wells, offshore
resources, ultra-deepwater, bitumen and other heavy oils). But in the
long term, anything over five years, the marginal cost of energy is
set by a much wider range of technologies, including coal (via
coal-to-liquids), natural gas (gas-to-liquids and LNG) and the power
generation sector.
Crude
oil and the products refined from it (principally gasoline, jet fuel,
diesel and residual fuel oil) have a special place in the energy
system owing to their exceptionally high energy density, which makes
them particularly suitable as transportation fuels. But the
technology to convert both natural gas and coal to liquids like
gasoline and diesel is well understood and competitive with crude at
prices well under $100 per barrel.
Shell
has already built one gas-to-liquids plant in Qatar. According to
press reports, the company has been studying the potential for a
similar one in Louisiana, to turn cheap U.S. natural gas into diesel.
Efforts are already underway to increase the direct use of natural
gas in the U.S. transportation sector, including using LNG in heavy
trucks, public transportation and potentially railway locomotives and
ocean-going shipping.
MARGINAL
COST < $100
It
may seem futile to try to identify a long-run marginal cost for oil,
given that it does not drive realized prices in the short term, and
is too dynamic to forecast five years or more into the future.
Nevertheless, to the extent that it is possible to identify a
long-term marginal cost, even if it is rather theoretical, it
probably lies somewhat below $100 per barrel.
This
is lower than estimates published by most oil analysts, which peg
marginal cost at $100 or more, based on increasing exploration and
production costs for unconventional oil resources, and the increasing
revenue requirements of Saudi Arabia and other OPEC producers.
But
it is consistent with the known economics of coal and gas to liquids
technology, as well as the use of LNG in the transport sector. It is
also consistent with the behavior of forward oil prices. Prices for
long-dated (Dec 2015) U.S. and Brent crude futures have been stable
at $83-106 and $84-109 per barrel respectively since the start of
2010 (Charts 1-2).
Forward
prices do not necessarily provide a particularly accurate prediction
of where the market will head over the next five years (just ask
anyone who bought Dec 2015 natural gas futures at more than $11 per
mmBtu in 2008 and now finds them valued at less than $5). But they do
encapsulate the current state of expectations.
Forward
contracts imply that oil prices are expected to drop below $100 per
barrel by the middle of the decade. At a first approximation, $90-100
appears to be a reasonable expectation for the long-run marginal cost
of oil outside North America, and perhaps $85-95 in the United States
and Canada, based on forward contracts for Dec 2015 and beyond.
Following
recent price falls, prices for both U.S. crude and Brent are now
close to these implied long run cost-driven levels. Dec 2015 futures
contracts are trading close to the bottom of their post-2009 range
for both WTI and Brent. Front-month prices have also been driven down
close to this level.
Oil
bulls will argue that marginal costs put a natural floor under the
market at $90-100 per barrel for Brent (and a little lower for WTI)
and help re-establish the case for taking a positive view for the
market in the short to medium term [ID:nL5E8HBESM].
Whether
it is enough to stabilize the market must remain doubtful. Gas
analysts have been waiting for marginal costs to provide some price
support without much luck for more than two years. It has taken 18
months to trigger a substantial supply response, and even that may
not be enough to clear the glut.
So
the fact oil prices are approaching long run marginal costs does not
eliminate short-term downside risk. Anyone who thinks prices cannot
fall further should review the history of gas predictions. But it
might just might indicate that most of the downward correction has
been completed, with further falls starting to curb supply growth.
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