Oil Prices: Everything You Think You Know Just Ain’t So

In July 2008, my Journal colleague Neil King asked a wide range of energy journalists, economists and other experts to anonymously predict what the price of oil would be at the end of the year. The nearly two dozen responses ranged from $70 a barrel at the low end to $167.50 at the high end. The actual answer: $44.60. __ http://fivethirtyeight.com/features/the-conventional-wisdom-on-oil-is-always-wrong/

But it didn’t take long for the “experts” to shake off the depressing effects of the 2008/2009 black swan, and revert to their earlier unbounded faith in oil’s inevitable, unstoppable rise in price.

And so, until a few months ago, investment bankers and pension managers considered oil to be one of the safest investments around. According to conventional wisdom, global demand could only go up, and oil supplies could only go down. In other words, the price of oil would continue to go up and up — making oil a sure investment bet “for all seasons.”

Back in August, Marks notes that investing legend Byron Wien met with “prominent investors” who all agreed that increasing emerging market demand would sent Brent crude prices from then-current levels of around $110 a barrel to $120 over the next five years.

“In economics things take longer to happen than you think they will, and then happen faster than you thought they could.” __ http://www.businessinsider.in/Howard-Marks-Gives-A-Crystal-Clear-Explanation-Of-How-Oil-Prices-Work/articleshow/45577149.cms

But reality cares nothing for conventional wisdom, as you can see from the price graphic above.

Global oil markets are a function of countless variables — geopolitics, economics, technology, geology — each with its own inherent uncertainty. And even if you get those estimates right, you never know when a war in the Middle East or an oil boom in North Dakota will suddenly turn the whole formula on its head. __ Conventional Wisdom is Wrong on Oil

One of the problems with predicting oil prices, is that most of the information used in such predictions happens to be seriously out of date:

Common sense suggests the near-halving of oil prices since June should already be affecting decisions about future supply and demand – everything from drilling plans to the type of cars consumers buy and their levels of discretionary driving.

But current information on almost every element of the supply-demand picture is seriously out of date – assuming it is accurate. Even in the United States, which produces the most comprehensive, accurate and timely statistics, the bulk of such data is up to three months old. __ http://eaglefordtexas.com/news/id/142682/clausewitz-oil-prices-kemp/

Besides supply and demand, and the strength of the US dollar, oil prices can be affected by distortions introduced by the mechanisms of the trading process:

In a recent 30-day period the price of oil fell by 20 percent. There was no change in the demand or supply over that month to justify such a large change. What happened is that commodity traders look at expected future prices, based on long-term supply and long-term demand. When the traders’ expectations change, they buy or sell and the price changes. Traders’ expectations can change due to moods, “animal spirits,” fear, greed, drugs, family strife or lack of coffee. Or too much coffee. Thus, short-term price changes can happen quickly. __ http://www.forbes.com/sites/billconerly/2014/12/18/oil-price-forecast-2015-2016/

Beyond the caprice and whimsy within the hearts and minds of big oil traders, there is plenty of room for intentional manipulation of prices. Prices are much easier to manipulate when oil production is a near-monopoly — as in the time periods 1974 — 1985, and 2005 — 2014.

At the present time, boosted production in non-OPEC countries — particularly in North America — is threatening OPEC’s almost total control over oil prices. Both OPEC and Russia would like to break the back of North American oil production if possible, and return to the era of high prices via quasi-monopoly. Euan Mearns says that this is already happening. He predicts stable prices near $60 bbl in 2015, but higher prices to $105 bbl in 2016 — mostly from loss of production in N. America due to fallout from current low oil prices.

A shakeup in N. American oil production is certain. Few new companies will get involved in shale oil and oil sands while prices stay low, and several companies will grow by taking over the assets of failed enterprises. But then, that is only business as usual in the oil trade, whenever monopolistic national oilcos are not in control. There are winners and losers.

Here is a brief picture of the complexity in the marginal oil production free-for-all:

Not all parts of an oil field are created equal. Wells drilled in a “sweet spot” can be an order of magnitude better than those in less promising areas. Companies will keep drilling in the best areas long after they’ve pulled the plug on more marginal prospects. Break-even prices also change along with the price of oil. As prices fall and companies drill less, that leaves more rigs and equipment available, pushing down the price of drilling a well and allowing companies to stay profitable even at lower oil prices.

With oil under $60 a barrel, it’s a fair bet that many U.S. wells are now unprofitable. But that doesn’t mean companies will stop drilling them, at least right away. Companies often have contracts for rigs and would rather keep drilling than pay a penalty. They also have contracts for the land where they drill. If they don’t drill within a certain period, they lose the right to the land altogether.

Even when drilling does slow, production won’t necessarily follow. Wells keep producing for decades after they’ve been drilled, although at ever-declining rates. Companies prioritize their most promising projects, so the wells that do get drilled will be the best ones. And technology keeps improving, so companies can coax more oil out of each well.

… In recent years, investors have handed energy companies half a trillion dollars in loans. That’s partly because of all the promising new oil fields in North Dakota and Texas, but it’s also because with interest rates near zero, investors are hungry for returns wherever they can find them. Now the Federal Reserve is talking about raising interest rates, which could kill the bond bubble, even as falling oil prices make those loans look riskier than they used to. If Wall Street turns off the money spigot, drilling will slow down no matter what oil prices do. __ Conventional Wisdom is Wrong

And then there is the question of how long OPEC and Russia will continue to produce at current levels. Russia, in particular, will find it more difficult to sustain production without foreign expertise and technology, while sanctions continue — and intensify.

Supply and demand, US dollar strength, new efficient technologies of production and discovery, animal spirits, outright market manipulation, geopolitical stability, diversity of oil production beyond monopolies, and other factors will continue to influence oil prices into the future.

Ongoing demographic collapse in the world’s more prosperous nations (and in Russia) will affect future demand, and future ability to maintain production (and to protect territorial integrity).

Expansion of Russian militarism into proxy wars — using cats paws such as Iran, Venezuela, and North Korea to create instability and supply disruption — could cause significant shifts in oil markets. Nuclear detonations in the middle east or inside Europe or North America, would force oil economists back to the drawing board.

When everything you think you know just ain’t so, it can be difficult to predict anything — especially into the future.

Hope for the best. Prepare for the worst. It is never too late to have a Dangerous Childhood.


No one knows where oil prices are going

OPEC’s big bet could easily go bad : Saudi royals and hangers-on have grown fat on overpriced oil. We’ll see how long their country can hold together when prices are $50 bbl below fiscal breakeven for the national budget.

Of course, the situations for Russia, Iran, and Venezuela are even worse.

Another coming huge boost in oil production

Hording cheap oil in hopes of higher prices in the coming years

Oil price wisdom from Vaclav Smil

More from Michael Lynch

Paleogeology and the great oil hunt

Ancient oil label on Al Fin Energy blog (scroll down)

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2 Responses to Oil Prices: Everything You Think You Know Just Ain’t So

  1. bob sykes says:

    At $60 per bbl, many fracked wells are unprofitable only in a technical accounting sense. The developmental costs are sunk costs. What counts are the marginal costs of pumping and distribution, and wells will continue to be pumped as long as market prices exceed or equal pumping and distribution costs. That is the only way to minimize putative losses.

    • alfin2101 says:

      Well said. Even doomers who have been predicting the collapse of shale oil for the past 5 years should be able to understand your explanation. But they won’t like it.

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