Crude Oil Price setting mechanisms 101

Oil ProductionCrude Oil

We have recently seen the price of Brent crude oil (the global standard) drop steadily from over 100 dollars per barrel to close to 80 dollars. The reason is a current small “oversupply” of crude at a time of slowing demand for gasoline and other crude-derived fuels. What are the factors at work here? To understand these, we can look at the left graphic from Reality Check as well as the right graphic, which shows the dramatic turnaround in U.S. crude oil production.

First, a comment about the bars that show production costs from various sources and regions. Crude oil prices normally reflect the sum of “finding” costs (exploration and well development) plus “lifting costs” (production from developed wells).  The U.S. Energy Administration in 2009 estimated U.S. total cost of crude oil production to be $31/bbl onshore and $ 51/bbl offshore.  Lifting costs were $12/bbl onshore and $ 10/bbl offshore. The U.S. still has over 5 MM bbls/day that can be produced at close to these relatively low cost, though this is not shown in the left graphic which presumably depicts incremental cost of new crude oil produced from  wells being developed in the different regions. Since almost all new U.S. crude oil comes from “fracking” in Texas and in the Northern U.S., no other U.S. oil prices are shown. Moreover, since fracking-based oil has an incremental production cost of $ 65 per barrel, new crude oil production here will keep rising unless world oil prices drop well below $ 80/bbl.

Looking at the other graphic, it is evident that the rapidly growing U.S. oil production, together with the instability of some OPEC sources (Libya, Iraq) is moving crude oil into an oversupply situation. The Saudis, with the largest production source, could cut back and stabilize the price, but they are apparently unwilling to give up market share to the U.S.

Let’s look at the price-setting mechanisms at work here. Short term, there is likely to be some cutback in production simply because refineries will need less oil to meet worldwide demand. This cutback will come from the more expensive shale oil and oil sands wells, from tertiary recovery, and from producers whose inventory tanks are full. As to demand, low crude oil prices make gasoline prices fall and that means more people will drive more miles, thus raising demand.  At some price, supply and demand must balance. It would be surprising to see oil fall much below, say, $ 70/bbl., short of a major economic slowdown.

Long term, other things come into play. Lower crude oil price forecasts will slow down offshore oil production investment and will cut back on more oil sands and Arctic  investments as well as more expensive fracking sites.

The laws of supply and demand are alive and well!

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