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Page added on May 19, 2014
Markets Work Or, How The Economics Of The Oil Industry Is Changing
Two interesting things we can glean from this report in the WSJ into the economics of the oil business. The first being that some people can be a little confused about the economics of pricing, the second being that markets really do work. For the first one we have an assurance that oil prices aren’t going to fall very far despite increased production:
For Western consumers, liberalization could mean more stability. Motorists would be less likely to suffer the sort of spike they saw in July 2008—when oil surged to $147 a barrel—if there were new sources of supply to ease the effect of disruptions elsewhere. But oil may not be much cheaper than today: Because much of this production would be in terrain that’s expensive to develop, prices would remain elevated and no lower than $70 a barrel, analysts say.
That’s not actually how pricing works you know. Everyone, at least every producer, would love it if it were, that your sales price was by some magic always kept above your production costs, but that really just isn’t the way that it works. And it’s especially not the way that it works in the oil industry. Which is an industry in which two things are true: firstly it’s a very long term industry, one that works on some of the longest timescales of any industry that we currently have (at first blush only the nuclear industry has a longer planning horizon) and it’s hugely capital intensive. It’s the setting up of an oilfield that costs all the money, not the running of one once developed. Secondly, the demand for the product is highly inelastic with relation to price. Put these two together and we can have huge swings in prices from relatively small changes in production. Meaning that just because certain oilfields cost $70 a barrel to exploit there’s no certainty at all that oil prices will remain above $70 a barrel.
The other issue is that even in a long term and capital intensive business like this markets do work, even if slowly:
The result: U.S. companies—and some European ones—are reducing their presence abroad. U.S. shale oil costs 14 times as much to produce as conventional oil in the Middle East. But operators get full ownership of production and projects—in contrast to Middle Eastern countries, where the lion’s share goes to the governments.
The background to this is that the governments of the various oil producing (and OPEC) members decided, decades back, that those foreigners exploiting the oil ought to be thought of as the hired hands rather than the owners of those natural resources. So the profits that the oil majors were allowed to make were squeezed: perhaps by nationalisation, perhaps just by very tough contract terms. But it was still true (and still is today) that almost all of the expertise about how to extract oil is in those majors. So, they’ve simply gone off and applied that expertise elsewhere. In places like the US where they’re not going to get expropriated. The end result of all of that is that much of the power in the oil market has, as the new production ramps up, flowed away from those oligopolists, those nations, and they’re now having to offer very much better terms to the oil companies to get them to come back and land their expertise to the development of further fields.
Another way we can look at this is that technology always, in the end, destroys a monopoly. OPEC had a great deal of market power but their very actions led to the development of the technologies that are undermining that market power. Which is what does, always, in the end happen if people try to restrict supply of whatever it is below market demand and thus keep price above the free market price.
13 Comments on "Markets Work Or, How The Economics Of The Oil Industry Is Changing"
Plantagenet on Mon, 19th May 2014 6:41 pm
Another reason that oil prices won’t fall is that the FED and the obama administration are systematically undermining the value of the dollar. By running huge federal budget deficits and printing trillions of dollars they have devalued the dollar vis a vis the Euro, resulting in higher oil prices and more expensive gasoline and energy costs for the American consumer.
GregT on Mon, 19th May 2014 8:08 pm
The US dollar has been ‘undermined’ since the US went off of the gold standard in 71.
If the trillions of dollars hadn’t have been printed, you would have much more serious things to worry about Plant, then the price of gasoline.
DMyers on Mon, 19th May 2014 8:30 pm
Plant makes a good point about money printing and resultant inflation of commodities.
The article engages in some faulty reasoning based on its faulty assumption; everything you’ve been hearing about the wonders of frack/horizontal are true, and due to that, we’re looking at huge oil supply potentials in this country. This potential will be captured by the relatively free market in US, as producers can find all kinds of creative ways to exploit this resource and keep the profits for themselves.
Since the mirage of vast [unconventional] oil resources is exaggerated and unrealistic, the market will soon hit a dead end, in that regard, and the disappointing supply will have disappointingly little affect on the market.
There are other issues here, which I’m too tired and lazy to address. One thing I would like to point out. The spike in oil to $148 in 2008 was a financial phenomenon, and a natural reaction to an impending crash of the dollar, not a result of a supply constriction. A huge supply of “kinda like oil” would have no balancing affect on circumstances which are entirely economic, monetary, and political in origin, having nothing to do with supply and demand.
rockman on Mon, 19th May 2014 8:44 pm
Wow! For a few minutes I thought Forbes would impress me…positively for a change. LOL. First, for the most part, the US shale players would not be spending huge chunk of capex overseas. They just aren’t built that way. OTOH Big Oil doesn’t function well in plays like the shales. Shell Oil did a bang up job in the last year of supporting that opinion.
And:”…that technology always, in the end, destroys a monopoly. OPEC had a great deal of market power but their very actions led to the development of the technologies that are undermining that market power.” The technology being used in the shale plays, while tweaked in recent years, has existed for more than two decades. Last I saw OPEC hasn’t lost control of the market place: oil selling around $100/bbl seems to be proof of that IMHO. And it’s that price which has justified the current shale development activity. Lower prices significantly and the shale plays die…”new technology” or not.
So based on the wise words of Forbes: “…and thus keep price above the free market price.” IOW Forbes concludes prices are right where they should be thanks to the free market.
Northwest Resident on Mon, 19th May 2014 8:59 pm
Plantagenet said: “…the FED and the obama administration are systematically undermining the value of the dollar…”.
Plant, as GregT points out, the actual truth is that without the many trillion$ in debt and QE funny money being added to the economy, the stock market would crash in a nano-second, banks and investors would go belly-up like cockroaches and you and I and everybody we know would be scrambling for survival or already dead. That time is coming anyway, soon enough, but with QE and the Fed printing all that money, they are buying time. I wouldn’t expect you to understand that simple fact, not when it is much easier to blame Obama.
And what, you think that Obama personally has the power to tell the Fed to add all those trillion$ to the national debt and single-handedly “undermine the value of the dollar”? That IS funny, in a pathetic kind of way.
Plantagenet on Mon, 19th May 2014 11:42 pm
Hi NW Resident Obama promised to cut the US deficit in half if elected. Instead, he doubled the deficit, and now about half the entire US debt has been created by obama. In case you didn’t notice, the US debt has now gotten so large that about $200 billion in general funds is now going each year just to pay the interest on the debt, with Obama clamoring for the US to borrow still more. Thanks to obama’s explosion of deficit spending, the US is now financially hamstrung when it comes to finding funds for more infrastrucuture spending and other needed reforms.
Plantagenet on Mon, 19th May 2014 11:45 pm
NW Resident: Its certainly nice that the US stock market has gone up, but its not surprising considering the loss of value in the US dollar. The Zimbabwean stock market went up a lot as the Zimbabwean dollar lost value too, but its madness for Obama to follow that failed financial example.
GregT on Tue, 20th May 2014 12:25 am
Plant,
At first I thought you were just trying to get people riled up with all of your ‘Obama’ comments. It is now very clear, that you have no understanding at all, about what is occurring in the world, or why.
While your two comments above are entirely true, the situation is far more complex than you seem able, or perhaps, willing to comprehend.
You are focussing on the symptoms of the underlying problem, rather than the cause.
steveo on Tue, 20th May 2014 7:15 am
“Obama promised to cut the US deficit in half if elected.”
So did Reagan, Bush, Clinton, and Bush. Counting Obama, that makes us 0 for 5 in my adult life.
R1verat on Tue, 20th May 2014 7:48 am
Anyone that knows the basics of how the US gov’t works realizes that the prez has little to no power to affect or correct many of the issues this site concentrates on.
Bush initiated our longggg war & contributed greatly to the deficit also, but it seems ‘popular’ now to blame Obama for many issues our Congress folks oversee. Very complex issues.
Northwest Resident on Tue, 20th May 2014 9:27 am
Simple minds seek simple solutions and simple answers. Simple minds, unable to grasp the complicated underlying issues, seek instead to “someone to blame”. Plantagenet is a prime example of this phenomenon. Blaming Obama for the federal deficit proves a total lack of understanding and critical thinking on Plant’s part. I guess now we understand what motivates Plant to constantly blame Obama for whatever is wrong on this forum — ignorance and lack of critical thinking. Heck of a job, Plant.
Beery on Tue, 20th May 2014 11:07 am
Let’s not forget racism. No-one who blames Obama for literally everything is ever going to admit it, but it’s there.
shortonoil on Tue, 20th May 2014 2:11 pm
“Another way we can look at this is that technology always, in the end, destroys a monopoly.”
Perhaps this is called “faith based” analysis; faith in the wonders of technology. A held dogma with the tenacity of religious rigorism. Interesting, the author goes on to say:
“It’s the setting up of an oilfield that costs all the money, not the running of one once developed.”
The great Middle Eastern fields came on line with a start up cost of $5.00 per barrel for the first day. The Bakken requires start up costs of $100,000 per barrel for the first day. Depletion, and the technology to access lower quality fields is adding to the cost of production. A point will be reached where the consumer can no longer afford the products produced. We have most likely already reached that point with shale. It is the energy produced from conventional crude that makes shale possible.
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