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Columnists love to brag when their speculations are borne out by subsequent events. Here’s an example of yours truly doing just that.

However, it’s only fair that this should be balanced by the occasional admission of error. For instance, back in August I wrote a Deep End piece entitled The oil industry – looking a bit peaky after all. As if on cue, the oil price began a sustained slide from around $100 a barrel to about $70 a barrel now – a four-year low.

Not exactly peak oil, is it?

In my defence, I should say that the theme of my article was that predicting energy prices is a mug’s game – I just didn’t expect the mug to be me.

Oil prices haven’t fallen this fast since 2008 – when there was an obvious economic explanation for the bursting of various commodity and asset bubbles. In 2014, however, there’s no global economic crisis (other than the after-effects of the last one). It has, of course, been a terrible year for events in the Middle East, but one would expect this to put upward pressure on the price of oil and gas.

What’s going on, then?

It helps to remember that oil is a rigged market, under the control of the major oil producing nations, most prominently those grouped together in the OPEC cartel. An optimistic reading of the current oil price fall is that new sources of production, especially those in North America using unconventional extraction methods like fracking, are weakening OPEC’s control.

However, as Shane Ferro and Gus Lubin explain in a briefing for Business Insider, it’s more complicated than that:

“Although no one is sure what’s causing the plunge in oil prices from above $105 a barrel this summer to below $80, Saudi Arabia, which helps control oil prices through how much of its vast oil reserves it releases to the market, would reportedly ‘be comfortable with lower oil prices.’ Meanwhile, there’s a risk that low prices will make it unfeasible to continue expensive unconventional drilling projects that are spreading through US shale basins.”

Shale oil is indeed a threat to the Saudi position, but the desert kingdom still has enough market power to sabotage the investment climate for the new industry. As an added bonus, the Saudis also get to make life difficult for their oil-producing geopolitical rivals like Iran and Russia – whose profit margins are tighter.

However, as our supermarkets could tell you, price wars come at a cost:

“…a massive new report, “The Rapid Rise of the United States as a Global Energy Superpower,” from Citi’s macro analysts suggests the price of oil would have to dip to the vicinity of $50 a barrel to flatten US production growth completely…

“The breakeven price for a well depends on a variety of factors. In places where the drilling infrastructure is mature and there’s not a lot of upfront capital costs to bring on a new well, breakeven prices are going to be a lot lower than in newer developing areas.”

The reduced oil price will most likely hurt the shale oil industry, not kill it. Meanwhile, on the home front, the loss of revenue hurts the Saudi state too. Their super-productive oil fields may have a low break-even price, but the cost of keeping their people happy in the wake of the Arab Spring is a lot higher.

Does that mean that oil prices are going back up again? I wouldn’t bet my house on it, but western governments shouldn’t take the current fall for granted.

Instead, they should take a good look at the most important graph in Ferro and Lubin’s briefing, which shows the break-even price for different forms of oil production. These are ranked from the cheapest, most productive sources (i.e. the onshore oilfields of the Middle East) on the left hand side of the graph to the most expensive, marginal sources (e.g. shale, ultra deep water and the Arctic) on the right. Broadly speaking, the future of oil is one of declining production from the easy sources that may or may not be replaced by new production from the difficult ones.

To literally look at it another way, turn the graph on its side – because like any limited resource, the long-term pattern of exploitation is to start with the low hanging fruit and then gradually move upwards. The end point of the process isn’t when all the fruit has gone, but when what remains is so hard to get at that it’s not worth trying anymore.

5 comments for: Why I stand by the oil price prediction that I got completely wrong

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