Tuesday, December 23, 2014

Energy Economics and the Price of Oil

The World will never run out of oil. The OPEC countries alone, which currently deliver 30% of the World's supply, have reserves sufficient to meet 100% of world demand for more than 30 years. But new discoveries and continual improvements in recovery efficiency — currenly only around 40% — imply that OPEC will have vast oil reserves 30 years from now even if they were to triple production from today onward.

At the current price of $55–60 per barrel, OPEC is collecting a tidy profit on oil produced at a cost of $25–30 on-shore or $40–50 off-shore, which raises the question: why should prices ever return to the $100-plus range of recent years?

As high cost producers cease producing, OPEC will be reluctant to fill the gap until the price of oil has risen to whatever price they are aiming for. Such an adjustment will likely occur rapidly because fracked wells, which account for much of the high-cost production, deplete rapidly — mostly more than 50% per year.

But no one can be certain at exactly what price OPEC producers can maximize net income, since that depends on all kinds of technological factors that influence the cost of unconventional oil production. The trend, however, will be to lower the cost of oil from shale, sands, and deep water. Moreover, it is unclear whether OPEC has any pricing power at all, given the propensity of members to cheat on one another by exceeding their production quotas.

What one can say, therefore, is that fracking is currently the main oil price balancing mechanism. When prices fall below the fracking break-even cost, fracked oil output declines sharply; when prices exceed the fracking break-even cost, fracked oil  output will rise quickly — it takes only weeks to complete a well, thereby capping any rise in price.

But there are three other factors that place upper limits on oil price. These are: (1) energy conservation as reflected, for example, in improved gas mileage of automobiles and reduced automobile use; (2) the transition of industrial energy users from oil to natural gas, which in North America, costs less than half as much as oil per unit of energy, and is in Europe, though more expensive, significantly cheaper than oil even at the currently depressed price for oil; and (3) a transition from oil to natural gas to power heavy commercial vehicles and to electricity to power light motor vehicles, which altogether now account for something like one third of global oil use.

Although wars, sanctions or other supply interruptions could drive oil prices back over a hundred dollars a barrel, during the next decade it seems that that oil will more likely average below, than above, $65 per barrel (in 2014 dollars).

However, conventional oil production is depleting at the rate of four million barrels a day. Assuming flat or rising oil demand, that means that at least that much new production must be brought on stream every year to keep prices relatively stable. If OPEC can and does boost production by something like four million barrels a day, then prices may not rise. However, some people doubt that OPEC has the ability to raise production by such an amount (more than 10% a year) year after year (see Boone T. Pickens in the video below). And if they cannot, then output will be maintained only at prices sufficient to bring new unconventional oil into production, which could be well above $65.00 a barrel.


T. Boone Pickens: Let's transform energy -- with natural gas

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