Perfect Harmony

By William M. Arnold 

This article originally appeared in The Hill and is reprinted here with permission.

News this week of oil prices hovering near $60 a barrel simply reflects the intersection of supply and demand. Demand is gaining strength as the global economy strengthens — supported by oil prices that are about half of their 2014 peak.

OPEC countries, led by Saudi Arabia and other large producers like Russia, have been more decisive and effective in controlling production. This is not to say that every large producer has cut back; however, the net effect has strengthened prices — but not to the point of killing off rising demand.

In the background are five drivers that get less attention: the small and decreasing imbalance between supply and demand, levels of investment, the normal operational decrease in production, the short-cycle nature of production in the U.S. and the inventory of oil.

In a world market of about 93 million barrels of oil and liquid fuels per day, an excess of supply over demand of less than 2 percent was enough to tank oil prices in 2014, driving them all the way down to the high $20s before climbing slowly to today’s prices.

This reflects the commodity nature of oil, the price of which will gravitate to the cost for the producer who supplies the last barrel to balance the market. Higher-cost producers will be driven out over time, although this may not be linear.

In a $110-plus price world, almost any production anywhere in the world was profitable but adversely impacted demand. But much lower prices put high-cost producers at a great disadvantage. That impacts remote areas like the Arctic, lower-quality crudes like those produced in Canada’s oil sands and in Venezuela, regions with poor infrastructure and deepwater production around the world.

Commodity prices are volatile in both directions. An oversupply like we have seen in the last three years drives prices dramatically lower, but a shortfall could take prices back to the former high levels. Is that likely to happen?

Over the last three years, companies have shed staff and slashed billions of dollars from investments to discover and produce oil in the future. That doesn’t have much impact on supply in the short term, but over three to five years, it will crimp production and trend toward higher prices.

Oil fields outside of OPEC on average decline by about 5 percent each year. That takes more than 2 million barrels per day out of global production. Companies are constantly on a treadmill to replace those reserves. Without new investment, that puts upward pressure on prices.

The “shale revolution” upset the traditional view of energy economics, because much of it is short-cycle. Instead of investing for production that won’t come onstream for three to five years, as in the case of deepwater or Arctic sources, production in places like the Permian Basin of West Texas has become more like a manufacturing process that can be turned off or ratcheted up in a matter of weeks, depending on oil prices and the cost of production at a given site.

OPEC has never seen this kind of competition before and is only now coming to grips with it. Adding to the disruption in energy markets has been the unanticipated but dramatic cost reduction of producing oil in the shale play. Former generalizations about the cost of production may be obsolete.

Initially, that was the result of hard bargaining between operators and service companies, but over the last three years, operators have employed new technology and processes to drive down costs more sustainably.

What this means is that absent a surge in demand or a dramatic shortfall in supply, say from a crisis in Venezuela, prices are likely to cap at West Texas costs of production that cover invested capital, probably in the $55-$60 range.

The final driver is inventory of oil. This has been at record levels while production outstripped demand. That has moderated in recent months, but still represents a limit on traders’ expectations of future prices. Stored reserves represent potential new supply that can cap prices.

Bringing all these factors together suggest that while oil prices may be “lower for longer,” an equilibrium has settled in. Demand has grown in response to moderate prices. Whether this will continue is not a foregone conclusion, as OPEC struggles with dissent among its members and there is no shortage of political instability around the world.

Over time, competition from natural gas and renewables cloud oil’s price horizon.

William Arnold is a professor in the practice of energy management at the Jones Graduate School of Business at Rice University.