What’s Next for Oil Prices?

If you haven’t noticed, the energy space is rife with debate. On the topic of natural gas, some argue that the U.S. possesses a 100-year supply of natural gas, while others argue that domestic reserves have been massively overstated.

In terms of American energy independence, there are those who think it’s coming by 2020, while others suggest that the U.S. will continue to rely on OPEC and other foreign energy markets for decades into the future. While these are incredibly important discussions, there is another debate that has received sparse attention as of late – the general direction of oil prices.

Let’s take a closer look at the two sides of this debate to get a better understanding of whether crude prices are likely to go up, down, or stay flat this year and in the longer term.

Oil bears vs. bulls
On the one hand are the oil bears. They argue that a number of forces will drive down oil prices as low as $50 a barrel, a level unseen since 2008, which was a year of spectacular volatility in the commodity markets. They suggest that technological advances, such as the commercialization of hydraulic fracturing and horizontal drilling, will continue to keep supply elevated far above demand.

Some also think that substitution, primarily through natural gas but also through alternative energy sources, will play an important role in keeping crude oil prices grounded for the foreseeable future.

On the other extreme are those that subscribe to the “peak oil” theory, which argues that global crude output peaked some time ago and is currently in secular decline. Their estimation of potential global oil supply would suggest that oil prices are bound to rise sharply in the near future.

So which side has it right? Or is the truth less black and white and more a shade of grey? Before addressing these divergent views, though, it might be helpful to understand the forces that determine the price of crude oil.

Crude oil price drivers
Crude oil prices are driven primarily by global supply and demand fundamentals, as well as other factors like geopolitical risk, the value of the dollar, and speculation. But over the long run, crude prices have shown a remarkable degree of correlation to what’s known as the marginal cost of oil production, which refers to the cost of extracting the last and most expensive barrel of oil from the ground.

Oil expert Chris Skrebowski estimates that marginal production costs are between $40-$80 a barrel in some OPEC countries, $70-$90 a barrel in Canada’s tar sands, and $70-$80 a barrel in deepwater. As a global average, he calculates that it costs somewhere in the range of $80-$110 in order to bring one new barrel of oil online.

A separate analysis by Bernstein Research reached similar conclusions. The study found that, in 2011, production costs for the world’s 50 largest publicly traded oil producers rose at a rate substantially higher than their long-run average. According to Bernstein estimates, marginal production costs increased 11% year over year and averaged more than $90 a barrel in 2011.

Soaring production expenses
Both studies highlight an important trend in the exploration and production business – it’s becoming much more expensive to extract the marginal barrel of oil than it used to be. It makes sense when you think about it. As oil and gas companies increasingly venture into unconventional sources of oil, such as shale and deepwater, they require more complex equipment and highly skilled workers, which don’t come cheap.

They also demand more natural resources, especially water, which is used extensively in the fracking process. Indeed, there are companies that cater solely to the water and wastewater needs of exploration and production companies. One of the more prominent water solutions company is Pennsylvania-based Heckmann Corporation (NYSE: HEK  ) , which I suspect has brighter days ahead of it due to strengthening demand for water purification and waste management services in the energy industry.

Indeed, one of the most distinguishable trends among explorers and producers has been a renewed focus on reducing operational expenses through improvements in drilling techniques, including more effective water-management practices. For instance, LINN Energy (NASDAQ: LINE  ) , which offered investors an enticing alternative way of investing in the company when it listed LinnCo (NASDAQ: LNCO  ) , structured as a C-Corp, on the NASDAQ last year, reported strong results in its oily plays largely on the back of improvements in water and wastewater management.

Another independent oil and gas company, Magnum Hunter Resources (NYSE: MHR  ) reported a sharp decline in its lease operating expenses per barrel of oil equivalent last year, as it brought on new unconventional production and managed its field operating expenses more stringently. Suffice it to say that reducing operating costs has become an overarching focus among exploration and production companies.

Final thoughts
As hordes of commodity traders will readily attest, predicting oil and natural gas prices ain’t easy. In fact, it’s really hard. But evidence suggests that the high marginal cost of oil production and the growth in unconventional sources of oil as a share of total global supply should effectively drive a floor underneath the price of oil.

Hence, while the price of crude oil could skyrocket due to a combination of unforeseen factors, it is likely to remain above the threshold level at which oil companies break even on their capital investments. But don’t just take my word for it.

Total‘s (NYSE: TOT  ) CEO Christophe de Margerie expects crude oil to remain between $105 and $115 a barrel for the year. He suggests – correctly, I think – that concern about geopolitical conflict in the Middle East is already priced in and is the reason why oil continues to trade at around $110 a barrel.

Of course, there are tail risks that could blow my theory out of the water. But, I suspect that upside surprises, which cause crude prices to soar, are more likely than downside surprises. Some of these could include the adoption of (even) looser monetary policy, the acceleration of geopolitical instability in the Middle East and other key supply regions, or a surprise pickup in global economic growth, particularly in China, the eurozone, the U.S., and other major oil markets.

If you’re convinced by the argument that oil prices will remain buoyed by the high marginal costs of production, then surely you’ll want to know how to invest around this theme. If you’re on the lookout for some currently intriguing energy plays, check out The Motley Fool’s “3 Stocks for $100 Oil.” You can get free access to this special report by clicking here.

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