John Kemp is a Reuters market analyst. The views expressed are his own.
Following recent falls, oil prices are much closer to the industry’s marginal cost, especially in North America, where light sweet crude futures are now valued at only a little over $80 per barrel.
For bullish investors, lower prices promise to provide support by threatening to curb rapid output growth, especially from high-cost tight oil and bitumen projects across the United States and Canada, as well as deepwater exploration, unless the global economy enters another tailspin.
But basing price forecasts on marginal costs is hazardous, as the troubled history of predictions for North American gas prices has shown over the last two years. Henry Hub prices have plunged through a succession of so-called price floors defined by estimates of marginal costs, first at $6 per million British thermal units, then $4, and most recently $2, triggering only very sluggish cutbacks by producers.
Oil prices could suffer the same fate. In the short run, commodity prices often deviate substantially from estimated marginal costs because both production and consumption are semi-fixed (the result of previous investment decisions). In the long run, competitive pressures force convergence, but marginal cost is itself a moving target, shifting as a result of changes in technology and industry structure, which are impossible to foresee with any degree of accuracy so far ahead.
“Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligibleâ€¦. We have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence” John Maynard Keynes wrote in 1936.
“It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain,” Keynes concluded (”The General Theory of Employment, Interest and Money”).
Investors typically fall back on a “convention” of “(taking) the existing situation and (projecting) it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.” This system may not be accurate or even realistic, as Keynes illustrated, but it reduces the enormous amount of uncertainty that would otherwise paralyze all decisions to make long-lived investments.
Pinning Down Costs
It is notoriously difficult to define marginal costs accurately. Estimates vary depending on the time frame used, the costs to be covered, and how marginal production is defined.
In the short-term, producers only need to cover the variable costs directly associated with operations. In the longer term, they also need to cover fixed costs for exploration and development. Estimates of long-run costs are extremely sensitive to assumptions made about the cost of skilled labor, materials and equipment, as well as improvements in technology and efficiency.
Then there is the question of “social costs,” which include a variety of taxes and royalties imposed by host governments, as well as price and revenue targets operated by the leading members of OPEC. Many oil analysts include tax and revenue requirements in their estimate of marginal costs on the grounds that OPEC producers and other states need certain minimum prices and revenues to balance their budgets and avoid social unrest.
But social costs are not really fixed in the medium term. Social spending in petroleum exporting states has always been pro-cyclical. Revenue requirements rise when oil prices are increasing, and tend to fall when oil prices come under pressure. In other words, prices tend to drive budgets, rather than the other way around.
Finally, there is the question of what constitutes marginal production. Analysts typically focus on a narrow definition of oil (including production from conventional wells, fracked wells, offshore resources, ultra-deepwater, bitumen and other heavy oils). But in the long term, anything over five years, the marginal cost of energy is set by a much wider range of technologies, including coal (via coal-to-liquids), natural gas (gas-to-liquids and LNG) and the power generation sector.
Crude oil and the products refined from it (principally gasoline, jet fuel, diesel and residual fuel oil) have a special place in the energy system owing to their exceptionally high energy density, which makes them particularly suitable as transportation fuels. But the technology to convert both natural gas and coal to liquids like gasoline and diesel is well understood and competitive with crude at prices well under $100 per barrel.
Shell has already built one gas-to-liquids plant in Qatar. According to press reports, the company has been studying the potential for a similar one in Louisiana, to turn cheap U.S. natural gas into diesel. Efforts are already underway to increase the direct use of natural gas in the U.S. transportation sector, including using LNG in heavy trucks, public transportation and potentially railway locomotives and ocean-going shipping.
Marginal Cost < $100
It may seem futile to try to identify a long-run marginal cost for oil, given that it does not drive realized prices in the short term, and is too dynamic to forecast five years or more into the future. Nevertheless, to the extent that it is possible to identify a long-term marginal cost, even if it is rather theoretical, it probably lies somewhat below $100 per barrel.
This is lower than estimates published by most oil analysts, which peg marginal cost at $100 or more, based on increasing exploration and production costs for unconventional oil resources, and the increasing revenue requirements of Saudi Arabia and other OPEC producers.
But it is consistent with the known economics of coal and gas to liquids technology, as well as the use of LNG in the transport sector. It is also consistent with the behavior of forward oil prices. Prices for long-dated (Dec 2015) U.S. and Brent crude futures have been stable at $83-106 and $84-109 per barrel respectively since the start of 2010 (Charts 1-2).
Forward prices do not necessarily provide a particularly accurate prediction of where the market will head over the next five years (just ask anyone who bought Dec 2015 natural gas futures at more than $11 per million Btu in 2008 and now finds them valued at less than $5). But they do encapsulate the current state of expectations.
Forward contracts imply that oil prices are expected to drop below $100 per barrel by the middle of the decade. At a first approximation, $90 to $100 appears to be a reasonable expectation for the long-run marginal cost of oil outside North America, and perhaps $85 to $95 in the United States and Canada, based on forward contracts for Dec 2015 and beyond.
Following recent price falls, prices for both U.S. crude and Brent are now close to these implied long run cost-driven levels. Dec 2015 futures contracts are trading close to the bottom of their post-2009 range for both WTI and Brent. Front-month prices have also been driven down close to this level.
Oil bulls will argue that marginal costs put a natural floor under the market at $90 to $100 per barrel for Brent (and a little lower for WTI) and help re-establish the case for taking a positive view for the market in the short to medium term.
Whether it is enough to stabilize the market must remain doubtful. Gas analysts have been waiting for marginal costs to provide some price support without much luck for more than two years. It has taken 18 months to trigger a substantial supply response, and even that may not be enough to clear the glut.
So the fact oil prices are approaching long run marginal costs does not eliminate short-term downside risk. Anyone who thinks prices cannot fall further should review the history of gas predictions. But it might just indicate that most of the downward correction has been completed, with further falls starting to curb supply growth.