Oil is too expensive – and too cheap – at the same time

Should we fear low oil prices even more than high prices?

This article is a translation of the original that was published in Kanava-magazine 4 / 2014.

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As the peaking of world oil production has been drawing nearer, the price of oil has roughly quadrupled in a decade as supply was not able to meet growing demand. This has had a major part in the economies and foreign trade balance of many oil-importing OECD-countries. Importing costs have ballooned due to higher energy prices while the value of exports have largely stagnated. Manufacturing industries have moved to China and other countries with cheap labor and lax environmental regulation. Many experts have been pondering on worrying scenarios on what will happen to our economies and balances if the price of oil keeps going up – perhaps doubling?

This threat is not an idle one. A white paper [i] published by IMF in 2012 modeled that if we aim to grow total oil production even by 0.9 % annually for the next decade, the price of oil must roughly double during the same period. So far, as the paper is more than 2 years old, nothing of the sorts has happened. OECD economists, on the other hand, modeled [ii] with their demand-driven model that oil prices will be between 150 and 270 US$ per barrel in 2020 (with base scenario at 190 $) if the global economy will recover close to levels seen in early 2000’s. This price-rise also assumed that there will be 14 mbpd of new production online by 2020, in addition to replacing 12 mbpd of current production depletion. If the production would fail to grow, the price would be nearer the upper limit of the scale.

The report failed to present much in the way of credible ways and sources for this production, although growing shale oil production was mentioned. The total world production of crude oil – even with the substantial additions from shale and oil sands in North America – have failed to grow significantly. Shale oil is produced mainly from Bakken and Eagle Ford more than 3 mbpd. This growth has been faster than many predicted just a few years ago.

Exploration and production development have not paid off

The role of shale oil as a major source of near future oil production just took a big hit, as EIA updated their estimates for the reserves in the Monterey shale in California. The cut to the reserve-estimates was a heart-stopping 96 % [iii]. Given that Monterey had roughly two thirds of the total U.S. shale oil reserves of around 13.7 billion barrels, the cut was also huge in absolute terms. The cut was based on a geologic study (while the previous estimates were largely based on oil-company marketing-materials, apparently), and it put the current economically recoverable reserves of Monterey at 0.6 billion barrels.

The price of oil has, for the few last years, been stuck at 100-120 US$ level, depending on the marker one uses. After some swings, it seems to return to those levels before long. The global economic problems have not gone away. The European economy continues on its way down the toilet, as does its use of oil. Even the meager growth in Europe has been financed largely on more and more debt. All the oil we have not used have found an eager buyer in China and India, amongst others. Practically speaking, China and India are pricing Europe out from the global oil markets. They have been at it for nearly a decade already.

Many estimates for future oil production have assumed that the price of oil will become as high as necessary to make adding new production economically viable. The price of this so-called marginal barrel has exploded in just a few years. This is mainly due to the nearing of peak oil, which means that there is no more cheap and easy oilfields to be found. In 2011 the price of marginal oil barrel in the U.S. was 89 US$. In 2012 it was 114 US$ [iv]. The price of oil, as mentioned before, has been near 110 US$, or even near 100 US$ if we look at the WTI-marker used in the United States. With a quick back-of-envelope –calculation that would mean meager, if not negative economics for exploration and development of new oilfields.

Shrinking Capex-investments will mean shrinking production

The International oil corporations have noticed these economics. Back in 2000, their total Capex-investments (total investments made for exploration and development of new production) were around 50 billion US$. In 2013 these investments had grown more than five-fold, to 260 billion US$. Despite this, the actual oil production of these companies did not grown. In fact if shrank during that time. They have been investing more and more, while getting less and less oil to the market.

With this, their ability to pay dividends has also been shrinking. The main reason behind this is that the markets (that’s us, you and me) have not been able to pay high enough price for the oil to make investing to the next marginal barrel economical. For 2014 Shell announced it will cut its investments by 20 %, ExxonMobil by 10 %, Chevron and Eni around 5 % [v]. If the growing investments only slowed down the decline of their oil production, what will happen to their oil production in a few years’ time if the investments start shrinking?

What if the price of oil won’t rise?

If our economy is in trouble partly because of high oil prices, this can mean ever worsening situation for the coming years. Our inability to pay higher prices is in ways even more scary than ever increasing prices of oil. It could mean that our economic problems will continue for years to come – no matter our chosen fiscal or monetary policy. It could mean that many oil-substitutes will not become competitive, as their manufacturing would need higher oil prices. Investments that increase oil efficiency will become less economic, as oil prices are not able to rise high enough to justify them. And finally the global oil production could start to fall earlier and more rapidly with lacking investments. This will make the already troubled economies suffer even more. The price of oil will not rise, but our relative ability to pay for it will decline faster than we can respond to.

If this is so, has oil already become too expensive for the current system? And is it at the same time too cheap to signal and encourage the markets to invest in oil efficiency and substitutes? This could lead to a situation, where most nations don’t see much need for radical measures, as the price of oil is not rising. At the same time, they will continue to search the reasons for the economic and social problems from and with political arguments and reasoning, as they have done so far.

Do we need to fear low oil prices – if they are because of our inability to pay and will lead to falling production sooner – even more than higher prices? Is this mechanism partly behind the current slump in oil prices and the gloomy world economy forecasts?

– Rauli Partanen
Head author of The World After Cheap Oil (Routledge 2014)
President of Peak Oil Finland

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Notes:

[i] https://www.imf.org/external/pubs/ft/wp/2012/wp12109.pdf

[ii] http://www.oecd-ilibrary.org/economics/the-price-of-oil-will-it-start-rising-again_5k49q186vxnp-en

[iii] L.A. Times 21.4.2014 – http://www.latimes.com/business/la-fi-oil-20140521-story.html

[iv] Financial Times 29.5.2013 – http://www.ft.com/cms/s/0/ec3bb622-c794-11e2-9c52-00144feab7de.html#axzz328ZWWR6O

[v] Businessday Online 12.3.2014 – http://businessdayonline.com/2014/03/decline-in-iocs-capex-amid-growing-oil-gas-discoveries/