Are You Expecting Oil Prices To Fall?

Includes: USO
by: Steven Hansen

Recent releases from the International Energy Agency tell of moderating growth rate of the global demand for oil - which was based on lower economic growth projections. And promises of "fracking" to boost oil supply are bouncing around cyberspace. Images of supply and demand curves flash in one's mind.

Yet, the cost of oil today has little to do with supply versus demand - but is more about marginal cost of supply and producers' ability to manipulate supply. Peak oil and anti-Obama rhetoric notwithstanding, oil production in the USA has been growing (see graph below).

There has been much hope for moderation of oil prices triggered by additional supply of crude being brought by fracking. The BBC reported:

The oil and gas industry in north-east Scotland has been warned it needs to adjust to the challenges and opportunities from "fracking" and other unconventional methods of drilling. They have already radically re-shaped the North American energy market. If deployed in other parts of the world, business consultancy Pricewaterhouse Coopers (NYSEARCA:PWC) said it could depress the price of oil. It said it could be up to 40% below the level it would otherwise reach by 2035.

Some believe fracking can make the USA energy independent. Roughly, that means the USA would double its production, freeing 6 billion barrels of previously imported oil in the global market. This will happen over a number of years - while the global demand is growing roughly at 0.9 million barrels per day each year. My belief is that fracking rate of growth is unlikely to grow faster than the growth rate of global demand for oil.

Most analysts make the mistake in believing that the USA lives in a vacuum. If it were possible to build a wall around the USA, it is likely the marginal costs (the all in cost for producing a barrel of oil) would be in the $60 per barrel range. [Note that I have read reports that the marginal costs for oil fracking in North Dakota is $40 per barrel.] The point here is that if the USA could isolate itself and if the production of oil could exceed demand, the price of a barrel of oil could be up to 40% lower.

But globalization equalizes commodity prices around the world, except for distribution inefficiencies such as are currently seen for natural gas. [hat tip for the below graphic to Cambridge Energy Research Associates ("CERA") via Safehaven].

There is "peak oil" depending on the price. At $80 per barrel, over 10% of the world's oil production is unprofitable to lift, and at $60 per barrel, 20% of the global supply of oil is too expensive to lift. Currently the average price per barrel averaging West Texas and Brent is running over $100 per barrel. It is fairly easy for OPEC and their associated members to withhold enough supply to keep oil prices from falling - as prices are influenced by the highest marginal rates.

A forecast for the future price of oil must take into consideration forces that are unforecastable. All forecasts for oil prices are worthless.

  • No ability to forecast oil producers' actions;
  • No ability to understand the changing mix between oil and other energy sources;
  • No ability to forecast USA government actions on oil producers including taxation, regulation;
  • No ability to foresee supply disruptions;
  • No ability to really gauge the global economy.

In this light, my worthless forecast is that oil prices will continue to bounce around - but the overall trend is up despite any growth in the supply of oil. To have oil prices fall permanently, there needs to be a quick and constant 20% improvement in supply, or a 20% drop in demand to nullify the ability of the oil producers to influence the price of oil.

And based on the short term trends in play - a major and permanent drop in demand or an increase in supply - this is not in the cards.

My normal weekly economic roundup is in my instablog, and looks at QE.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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